[This article originally appeared in the July issue of our Exchange-Traded Funds Report.]

When it comes to commodity indexes, the S&P GSCI is far and away the leader. More than $100 billion in assets is tied to this index, including nearly $2 billion split between two popular exchange-traded products: the $1.7 billion iShares S&P GSCI Commodity-Indexed Trust (NYSE Arca: GSG) and its smaller cousin, the $121 million iPath S&P GSCI Total Return Index ETN (NYSE Arca: GSP).

The two products aim to do the exact same thing: provide investors with exposure to the S&P GSCI Total Return Index. Compare recent returns, however, and you get two very different pictures: As of June 6, GSG had returned 3.95 percent year-to-date, while GSP had returned 6.03 percent. Considering that the actual S&P GSCI benchmark is up 6.13 percent, GSG has underperformed expectations.

Do investors have this wrong? Is the $1.7 billion in GSG tracking an inferior product? Should they swap out for GSP immediately?

Not necessarily—the story is more complex than it looks.

Two Approaches To Tracking The Index
While GSP and GSG aim to track the same index, they do so in different ways that promise two different kinds of results.

As an ETN, GSP eliminates tracking error. ETNs are structured as debt notes, whereby the underwriting bank—in this case, Barclays Capital—guarantees to deliver the exact return of the benchmark index. Barring unusual events, ETNs will track nearly perfectly to their indexes, and GSP has delivered on this promise.

There is no such thing as a free lunch, of course, and the perfect tracking of GSP comes with an important caveat: counterparty risk. As a debt note, GSP is fully susceptible to a default by Barclays. In the event that Barclays defaults, GSP investors will face substantial losses. The worst-case scenario is something akin to the failure of Lehman Brothers in 2008, which essentially wiped out investors in three ETNs issued by that company.

GSG doesn’t share that counterparty risk; it is structured as a trust. That means it actually purchases and holds assets designed to provide exposure to the S&P GSCI. Shareholders in the fund have a pro rata stake in those underlying holdings, and no default by iShares’ parent company BlackRock can take that away.

GSG is a bit unusual in that, unlike most commodity ETFs, it purchases a specific type of futures contract traded on the Chicago Mercantile Exchange called commodity excess return futures, or CERFs. Unlike traditional futures contracts, CERFs are designed to provide long-term exposure to a given asset class. The CME has listed two CERF contracts since 2006, which have had durations of five years and three and a half years, respectively. That contrasts with typical futures contracts that expire monthly or quarterly.

There are a number of potential reasons why iShares chose CERFs rather than traditional futures contracts to underlie the GSG product. The first is transaction costs: By having to roll over its contracts less frequently, GSG should reap savings—at least in theory. That’s offset by the fact that the CERFs GSG holds are relatively illiquid. iShares dominates the market for CERFs, holding more than 88 percent of the current open interest.

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