Monday, March 1, 2010

The Problem with Commodities ETFs

Last week, Hard Assets Investor published another one of my articles. In it, I compared the correlations between several energy ETFs and the prices of commodities they are tracking. The takeaway message is that, for the most part, ETFs do a bad job tracking commodities prices. There are a few reasons for this.
The first, and primary reason why the correlation is less than perfect, is that the front-month futures contract for every commodity is constantly changing. Since most ETFs hold only the front-month contract, this means that sometime before expiration, the fund must sell its holding of one (soon to expire) contract and then purchase another (soon to be front-month) contract. There is almost always a significant discrepency between the two prices, particularly if it's a commodity that doesn't deliver every month. Take a look at the futures chains on the CME group website for crude oil, gold, and corn. As of writing, the difference between the front month and second month contract is about 40¢, $1, and 10¢, respectively. That may not seem like much, but that price difference represents a pure loss in the value of the fund with every roll that takes place. Just to prevent declines, the fund would, on average, have to be increasing in value between 1 and 5% a month. That means that, depending on the commodity and the fund, a monthly percentage increase, if not sufficiently high, may actually mean you're losing money.
The second problem with ETFs is that they create a secondary market on top of what is already a volatile market in its own right. And, while the underlying instruments are the same for both, (futures contracts) the factors driving the supply and demand may be drastically different. For example, while natural gas might be moving up on strong demand resulting from a particular weather forecast, if the primary participants are energy hedgers, no such demand would exist for UNG, the world's biggest natural gas etf. As such, UNG might theoretically follow the price of gas with something of a lag, rather than actually track the price in real time.
Don't take my word for it, take a look at this graph comparing oil price movements with the price of USO, the world's biggest crude oil ETF, over the last four years:
Now, you might be saying "those charts seem to follow each other reasonably well" but that's the problem. Reasonably well isn't good enough. An investor buying a share or shares in a commodity ETF that puportedly tracks the price of a commodity wants her investment to actually do just that, not merely track the price "reasonably well".
It's true that there are some ETFs, especially those dealing with precious metals, that eliminate the problem of the roll yield altogether simply by buying and hoarding the commodity in question and storing it in a vault somewhere; no futures contracts required. While certainly effective in mitigating the problem, this only works for a very specific subset of commodities that do not have a cliff for their usefulness. Other than those few cases, in general, the moral is that if you really, truly want exposure to commodities, don't waste your time with an ETF. As they stand, very few of them can be relied upon to achieve their goals. Though that may change in the future, for now, your best bet is get into the futures market directly.


emthree said...

When we buy futures contracts for exposure to commodities, are we not facing the same issues as the commodity ETFs ?

When a futures price curve is in contango, we are still paying a premium for the future months and that premium will erode if spot prices do not increase over the life of the contract.

Take Chicago Wheat, for example.
Spot May/2010 is 493'4. May/2011 is 582'0 - an 18% premium.

Besides that, there is no trading volume beyond Dec/2010. So, it will be hard even for smaller accounts to get orders filled more than 9 months forward.

Is it unrealistic to compare the performance of ETF to the 'spot' price of the underlying commodity because the spot price cannot be achieved even buy directly buying and rolling over futures ?

Charles said...

Hi emthree,

Thanks for the comment, and you're right, there's some onus on me here insofar as I didn't really provide an explanation of how I suggest an investor invest in commodities.

However, the problem is not entirely the result of the roll yield. For example, you say "When we buy futures contracts for exposure to commodities, are we not facing the same issues as the commodity ETFs ? ".

The answer, surprisingly, is no, and this is what I wanted to address with my SECOND reason why Commodity ETFs are problematic. Take, specifically, the price of front-month natural gas, and that of UNG. The front month natural gas contract increased 59% in price from September 3rd to September 25th while UNG increased only 33% during the exact same period. The contracts rolled on the 28th that month, so no roll yield could have conceivably factored into this discrepancy.

The problem with commodity ETFs from an investor's point of view is twofold:
1) Investors think they're buying an investment that tracks the SPOT PRICE of the commodity. It does not.
2) The ETFs don't even do a great job tracking the front month, even accounting for the roll yield.

I seem to have generated some serious confusion here, so I'll write a bigger post explaining this in a day or so.

Unknown said...

Best to stay away from those "investmentU" links. InvestmentU = Sleazy.

Charles said...

Hi Stick,

I don't have any sponsorship deals, so I'm not sure I follow you here. Where are those links showing up?