Commodity ETFs: Returns May Not Always Match Expectations
By: As investors continue to pile money into exchange-traded funds, they are finding out that some of them aren't what they're cracked up to be.
Specifically, commodity ETFs—a relatively recent creation among funds—have often underperformed the goods they are supposed to track.
Some of the most popular oil funds have sharply trailed the commodity as it has risen some 80 percent this year. And if current trends persist and oil prices keep going higher, investors will need to take even more caution when buying ETFs.
"If they want exposure to gold, oil, natural gas—that's definitely preferable to opening of a futures contract and trading futures on their own," says Paul Brigandi, portfolio manager at Direxion, which runs a family of ETFs. "It's still the best way for investors to get involved. But they have to do their due diligence, read the prospectus—it's just a matter of doing their homework."
Investors looking to buy into the commodities boom of the past year have been scooping up ETFs that are designed to track various products, such as gold, silver, oil and grains. Unlike regular index funds, ETFs trade like stocks and are priced throughout the day, not just after the close.
The most popular gold ETF, the SPDR Gold Shares, has been pretty efficient in tracking the metal's movement as it has soared to a record high in 2009. The ETF's price has been highly efficient, with its value trading about one-tenth of the spot gold price, largely due to the fund's holding of physical gold.
That's not so true for the US Oil Fund, which missed much of crude's rally in the early part of the year, though it has tracked more closely to the commodity's price for the third quarter. Other popular oil ETFs that have met a similar fate this year include the PowerShares DB Oil Fund and the United States 12 Month Oil Fund, even though both have posted healthy gains.
The reason is a phenomenon in the futures market known as contango—the price of oil is higher for the coming months than it is in the current, or front, month. For an ETF like USO, which has to sell its futures contracts each month, it means buyers are buying high and selling low.
As contango has eased in recent months, investors in USO have fared better, but the longer-term picture hasn't been as good.
"We've decided never to do USO again," says Kathy Boyle, president of Chapin Hill Advisors, a boutique investment firm in New York that heavily employs both so-called "plain vanilla" ETFs that go up and down on a 1-to1 basis when the market does, as well as the more exotic bear funds that can pay double and triple when the market goes lower.
"The problem for individual investors is if there is an inefficiency of contango, the institutional guys know how to play it and take advantage of that, and the little guy is left way in the dust," Boyle adds. "They're sitting there in a jalopy trying to get it cranked up while this (institutional) guy is in a Ferrari a mile ahead of you."
The problems complicate as ETFs continue to spawn and grow beyond simple broad index plays and move into sectors.
There are now more than 850 ETFs trading, and September saw funds under management swell to more than $700 billion for the first time. Average daily volume for ETFs is up 11.5 percent in 2009 and increased 9.1 percent in October over September, according to NYSE/Euronext data.
While the funds are fairly transparent, investors need to check under the hood to make sure they're getting what they think, particularly when it comes to both bear and bull funds that pay in multiple movements down or up.
Double-down, double-danger
"The biggest negatives on these double-inverse and double-up ETFs is when the market direction is with them you make a lot of money," Boyle says. "If the market has as much volatility as we've seen, you can dramatically lose money very quickly."
Double-down bear funds can be particularly tricky for commodities because of how much futures trading can affect their performance.