Commodity exchange-traded funds (ETFs) invest in commodities by purchasing futures contracts or holding physical commodities in storage. Several commodity ETFs offer exposure to a single commodity or to various commodities. The PowerShares DB Commodity Tracking ETF (NYSEARCA: DBC) tracks an index that includes 14 of the most heavily traded liquid and import physical commodities.

What It Tracks

DBC seeks to track fluctuations in the level of the DBIQ Optimum Yield Diversified Commodity Index Excess Return, the fund's benchmark index, plus the interest income earned from DBC's holdings of U.S. Treasury securities, before fees and expenses. DBC's benchmark index tracks 14 commodities included in the agriculture, energy, industrial metals and precious metals sectors. The benchmark index includes gasoline, heating oil, Brent crude oil, WTI crude oil, gold, wheat, corn, soybeans, sugar, natural gas, zinc, copper, aluminum and silver.

By design, the benchmark index selects its securities based on the futures curve, and it is intended to minimize the effects of contango and maximize the effects of backwardation. Contango occurs when the price of a futures contract is greater than the commodity spot price, while backwardation occurs when the opposite is true.

How It Tracks It

DBC seeks to achieve its investment objective by investing in a portfolio of futures contracts on the commodities comprising the benchmark index. As of June 30, 2015, DBC allocates 12.02% of its portfolio to RBOB gasoline futures, 11.34% to heating oil futures, 11.11% to Brent crude oil futures, 9.65% to WTI crude oil futures, 9.61% to gold futures, 7.55% to wheat futures, 6.97% to corn futures, 6.88% to soybean futures, 4.98% to sugar futures, 4.73% to natural gas futures, 4.36% to zinc futures, 4.33% to copper futures, 4.11% to aluminum futures and 2.35% to silver futures.

Futures contracts on these commodities are contractual agreements that allow investors to buy or sell a particular commodity at a predetermined price on a future date. Some of these commodity futures contracts may be settled in cash or called for physical delivery.

DBC implements a rule-based strategy when it rolls its futures contracts – when it sells the nearer dated futures and purchases further dated contracts. Unlike many commodity ETFs, DBC does not purchase its commodities futures contracts based on a predetermined schedule. Rather, DBC rolls its futures contracts based on the shape of the futures curve, which helps to generate the best potential implied roll yield. As a result of DBC's rule-based approach, it can potentially maximize the roll benefits during backwardation markets and potentially minimize the losses from rolling its futures contracts in contango markets. The fund's high expense ratio, illiquidity of underlying futures contracts and the transaction fees incurred when rolling futures contracts contribute to the its moderately high tracking error of 0.3%.

Management

DBC was issued by Invesco PowerShares and is a part of Invesco's PowerShares Alternative - Commodities ETF series. This series offers ETFs that track single commodities, such as gold, silver and oil, as well as ETFs that track multiple commodities within one or more sectors. These commodity ETFs were developed by Deutsche Bank and provide investors with options to gain exposure to the commodity market.

Invesco PowerShares Capital Management is an investment management company and has been a subsidiary company of Invesco since 2006. Invesco PowerShares offers approximately 140 U.S. and non-U.S. ETFs and has $792.4 billion in assets under management. Invesco offers investors nearly 70 years of investment management experience and provides many options to suit investors' objectives.

Characteristics

DBC is legally structured as an open-ended fund, and it rebalances and reconstitutes its portfolio annually in November. Since DBC uses a specialized rolling strategy and tracks multiple commodities, it charges an expense ratio of 0.85%, which is in line with the average expense ratio of commodities broad basket funds. As of June 30, 2015, DBC has a weighted average market cap of $2.5 billion. DBC is considered a smart beta fund, which seeks to reduce the overall portfolio risk using Deutsche Bank's Optimum Yield strategy.

Suitability and Recommendations

Since commodities are globally consumed, it is difficult to determine future price movements, as well as supply and demand levels. The speculative nature of DBC's underlying holdings means that the fund is not suitable for all investors due to the high degree of potential volatility. Based on trailing five-year data, as of July 31, 2015, DBC has a standard deviation of 17.5%, while major market indexes, such as the S&;P 500 TR Index, experienced a lower degree of volatility. The degree of risk in investing in DBC is shown in its modern portfolio theory (MPT) statistics.

Based on trailing five-year MPT statistics, DBC's alpha (against the standard index, the Morningstar Long-Only Commodity TR Index) indicates the fund underperformed the standard index by 3.01% on a risk-adjusted basis. DBC's Treynor ratio (against the standard index) indicates it lost 7.44% per unit of risk on a risk-adjusted basis, which is not favorable to investors seeking to outperform the overall market.

In terms of MPT, DBC is best-suited for long-term value investors with high risk tolerances who seek exposure to the commodities market, and who believe commodities are undervalued at their current price levels. DBC is also suitable for investors seeking to stave off inflationary risks that can impact their overall portfolio. During times of inflation, commodities can serve as a hedge due to their negative correlation to bonds and equities.

How Financial Adviser Clients Could Use This ETF

Financial advisers can use DBC to add value to their clients' equity and bond portfolios by hedging inflation. DBC allows investors to place a tactical trade on unexpected inflation increases, since it has a low to negative correlation to other asset classes. If investors believe the U.S. Treasury is continuously printing money without reason, which causes inflation to increase, DBC can add value by providing diversified exposure to various commodities.

However, financial advisers should inform clients about the fund's high expense ratio and tracking error, which can be expensive for some investors to hold for long periods of time. Similarly, since the fund invests in futures contracts, financial advisers should indicate that investors may lose a substantial amount of their investments due to the speculative nature of these derivative contracts.

Main Competitors and Alternatives

The iPath Bloomberg Commodity Index Total Return ETN is an alternative and competitor to DBC. The exchange-traded note (ETN) tracks a broad index of front-month commodities futures contracts. It offers an expense ratio of 0.75% and provides exposure to 10 commodities in various sectors.

The GreenHaven Continuous Commodity ETF is another competitor and alternative to DBC, providing exposure to 17 commodities included in an equal-weighted index. The ETF seeks to minimize the effects of contango by investing in futures contracts across the nearest six months of the futures curve. The fund rebalances its portfolio daily to main equal weights across all commodities.

Unlike DBC, the First Trust Global Tactical Commodity Strategy Fund is an actively managed ETF with an expense ratio of 0.95%. This ETF provides exposure to commodities through its holdings in its subsidiary company. The fund takes a risk-managed approach to commodities investing and seeks to provide investors with higher risk-reward ratios. The First Trust Global Tactical Commodity Strategy Fund provides exposure to 10 to 35 distinct commodities based on their liquidity and implements an investment approach that seeks to maximize returns based on the level of volatility in the commodities.