Inside The Crash In Cotton ETFs [iPath DJ-UBS Cotton Subindex Total Return SM Index ETN, iPath Pure Beta Cotton ETN]

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July 23, 2014 5:33pm NYSE:BAL NYSE:CTNN

cottonThanks to extreme weather in some parts of the globe and supply disruptions in others, many commodity ETFs have put up solid performances so far this year. Some of the sectors in the space, including oil, precious metals and some base metals

, have easily managed to match the 8% return generated by the broad equity markets while some have even outpaced them.

However, the returns have in no way been universal as some commodities have performed quite miserably. Interestingly, the soft commodity space (represented by the ETF (NYSEARCA:DBA) – a group that includes products such as coffee, cocoa, sugar and cotton – has seen pretty varied performance.

Coffee and cocoa have easily managed to beat the returns of the broader equity markets and agricultural commodity ETFs, with coffee being the top performing commodity having delivered a handsome 50% return YTD. In contrast, cotton has been the worst performing commodity this year, while sugar has also not fared well.

Inside the Crash in Cotton ETFs

Cotton prices have recently crashed badly to reach the lowest levels in two years on expectations of a bumper U.S. cotton crop this year. In fact, they have been declining for 11 weeks in a row and are believed to have entered a bear market.

The U.S. Agriculture Department has recently raised its estimate for U.S. production by 10% to 16.5 million bales in the year beginning August 1. This is nearly 3.6 million bales higher from 2013-14 levels. Higher-than-expected production levels have taken a toll on cotton prices which are slumping badly (read: 4 Great Reasons to buy Commodity ETFs Now).

Making matters worse, China, the top importing country, has been steadily reducing its purchases of cotton due to a revision in its farm support regime policy, which has resulted in huge stockpiles.

Moreover, a shift towards alternative fabrics like polyester is leading to a slowdown in cotton demand, which is also putting pressure on prices. Experts believe that demand for cotton can only pick up when its prices fall to the levels of polyester.

Cotton ETFs in Focus

A brighter supply picture and slumping demand have caused cotton prices to suffer badly and in turn have impacted the performance of cotton ETFs (read:Palladium: The Next Hot Commodity ETF?).

Below we have highlighted two cotton ETFs, which have disappointed this year. Investors should clearly avoid these ETFs for the time being given the unfavorable demand supply imbalance in the cotton industry, with the production situation clearly in favor of the bears.

Moreover, both the products have a Zacks ETF Rank #5 or Strong Sell rating, indicating that they are likely to under perform the broader markets in the short run.

iPath Dow Jones-UBS Cotton Subindex Total ReturnSM ETN (NYSEARCA:BAL)

BAL is the worst performing ETF in the broad commodity space, having slumped 14% in the year-to-date frame. The product manages an AUM of $15.5 million and sees light volume of more than 10,000 shares a day.

The fund tracks the Dow Jones-UBS Cotton Subindex Total Return to provide exposure to futures contracts on cotton. The Index currently consists of one futures contract on the commodity. BAL charges 75 basis points as expenses.

iPath Pure Beta Cotton ETN (NYSEARCA:CTNN)

This ETN tracks the Barclays Cotton Pure Beta Total Return Index. Though the index normally holds one futures contract, it may roll into one of a number of futures contracts with varying expiration dates, as selected, using the Barclays Pure Beta Series 2 Methodology.

The product, however, is quite unpopular and illiquid with an AUM of $2 million and average trading volume of less than 1,500 shares a day. CTNN charges the same fees as BAL from investors.

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