Commodity ETFs Revisited

Aug 30, 2010

           

IFA has consistently warned the investing public to steer clear of commodities. See here and here for two examples. The reason for this is quite simple. Commodities (or commodity future contracts) do not carry an expected return like equities and bonds. They are simply a bet on the future direction of the price of a good. In other words, they are simply a form of speculation which has zero expected return before costs and thus a negative expected return after costs. Futures markets are dominated by big institutional players like oil companies and large banks (think Goldman Sachs); retail investors can rightly expect to be parted from their money in short order.

Once the exclusive province of “sophisticated” investors, commodities have been made accessible to everyone thanks to a slew of exchange-traded funds such as USO (United States Oil) and UNG (United States Natural Gas). At the end of 2009, investors held $277 billion in commodity ETFs and other securities linked to raw materials—a 50-fold jump from $5.5 billion a decade earlier, according to the Bloomberg Businessweek article cited above. Investors who acted on their hunches about rising oil and natural gas prices and bought into these funds have been met with bitter disappointment. Buyers of USO at its inception date of April 12, 2006 have lost 48% of their investment as of July 31, 2010, even though the price of crude oil has actually risen by about 12%. The story is worse for UNG. Buyers of UNG at its inception date of April 18, 2007 have lost 84% of their investment as of July 31, 2010, even though the price of natural gas has dropped by about 40%. If you are shaking your head in disbelief, wondering how this is possible, keep reading, but it’s going to get a little technical.

The problem, in a word, is “contango”. If you ask the broker who wants to sell you USO and UNG what this means, he probably will not know. Contango refers to the situation where futures prices follow an increasing pattern by duration of the futures contracts. For example, if the 30-day oil futures contract is priced at $75 and the 90-day contract is priced at $80, then the market is said to be in contango. Why does this matter? Because commodity ETFs never actually hold the commodities themselves (due to high storage and insurance costs). Instead, they hold futures contracts that have to be replaced when they get close to expiration. In a contango market, the difference in price between the existing contract and the replacement contract is a direct cost to the ETF. The problem becomes more acute when you consider that the professional commodity traders know exactly when the commodity ETFs will have to roll over their contracts and can game them accordingly.  In the words of Emil Van Essen, founder of a commodity trading firm in Chicago, “I make a living off the dumb money...These [commodity] index funds get eaten alive by people like me.” If you think of the dumb schmuck sitting at the poker table with his cards laid out for everybody to see, this statement is quite easy to believe. Greg Forero, Former Director of Commodities Trading at UBS, put it this way, "You walk into a casino, you expect to lose money. It’s the same with these products. You’re playing a game with a very high rake, a very high house advantage, and you’re not the house”.

Unfortunately, the beating has not been limited to retail investors. CALPERs (the California Public Employees’ Retirement System), the largest public pension fund in the U.S., has lost over $120 million in commodity futures since 2007, according to Bloomberg Businessweek. This misadventure will ultimately be paid for by California taxpayers, and perhaps by the rest of the U.S., should California require a bailout.

IFA’s advice to investors remains unchanged. Take the risks that are worth taking and avoid the ones that are not.