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.
"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.
Take the ProShares Ultra S&P 500, which is supposed to capture twice the move of the broad index. For 2009, the S&P 500 is up 21 percent, but the double-up ETF has gained only 29 percent— still a nice return but 50 percent less than what would be expected if the two entities had been perfectly correlated through the year.
"The problem is they rebalance it every day, so you don't get the compounding effects that one would expect if you look at the difference between doing something every day and letting the compounding effects ride over time," says Dirk van Dijk, analyst at Zack's Equity Research. "The longer the time, the bigger the diffrential will be."
Interestingly, the SSO's sister fund, the ProShares UltraShort S&P 500 , is supposed to register double the inverse performance of the broad index and has been pretty well on target this year with a 43 percent drop, just more than double the index's gain.
But many double- and triple-inverse bear ETFs, especially those that trade on low volume and liquidity and have large bid-ask spreads, aren't as neatly correlated and can sting investors who hold them too long.
"It's a tactical trade, it's not a long-term investment," van Dijk says of the inverse ETFs. "Over time the rolling of futures means that the correlation will tend to break down, and of course you've got the management fees."
Another issue for ETF correlation would be pending position limits being contemplated by the Commodity Futures Trading Commission.
The CFTC is expected to pass some type of new position limits for energy trading to curb speculation that some believe is responsible for the volatility in prices.
The PowerShare Dollar Index briefly halted trading recently over concerns about a filing for a new offering. The dollar has been tied to the rise in oil prices and gains in other commodities.
Also, the United States NaturalGas suspended creation units over concerns on CFTC regulations.
"They took a conservative stance and said we're going to stop accepting creation units because we don't know what the future holds on position limits," Direxion's Brigandi says. "The pending CFTC position limits will have some type of effect on the commodities ETFs."
Still, Brigandi says ETFs are a preferable strategy to physical posession of most commodities despite their challenges.
"For a retail investor that wants to get exposure to commodities, the ETFs right now are the best way. They're liquid, they trade in the secondary market and they're transparent for the most part," he says. "Investors just have to do their homework."