ETF Edge

Oil ETF overseer addresses the risks of investing in crude-based funds

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U.S. Oil Fund's top competitor breaks down state of crude oil ETFs

ETFs have found themselves at the epicenter of the crude oil collapse.

One exchange-traded fund in particular — the United States Oil Fund — has been under extensive pressure in the wake of last week's collapse oil price futures.

The unprecedented move into negative territory forced the USO to restructure several times by dumping shorter-term futures contracts to avoid imploding on its many retail investors. It has also made the fund a target of short sellers betting against its survival.

All this has made some in the industry question whether more education or warning should be required from companies offering ETF products that trade futures contracts.

The key is transparency, said Jason Bloom, who oversees the Invesco Oil Fund (DBO), USO's top rival fund.

While both USO and DBO have fallen precipitously this year, DBO has held up relative to its peer, with a 51% loss versus USO's 83% decline.

"USO and DBO are similar in that they're both ETFs and they both hold WTI futures contracts, but that's about where it ends," Bloom said Monday on CNBC's "ETF Edge."

"DBO since its inception over 10 years ago has always used an optimization process in selecting which futures contract to own," said Bloom, Invesco's director of global macro ETF strategy. "Occasionally, they own the front part of the curve, which USO used to own exclusively until the several changes recently."

That "optimization process" involves a cost-effectiveness calculation on DBO's part. Before its futures contracts roll over, the fund determines which futures contract has the best "cost of carry," Bloom said.

"In some cases, it's actually positive income if the futures markets are backward-dated," which happens when the current price rises above the price of longer-dated futures, he said.

Right now, the opposite is happening with oil prices — they're in contango, which means longer-dated futures prices are higher than the spot price of crude.

"Contango means that there's a negative cost, there's a cost burden on the investor, to hold that futures exposure over time," Bloom said. "DBO seeks to minimize that cost in a contango market. We currently hold the March 2021 futures contract, which is pretty far out the curve, and it hasn't really been subject to some of these issues we've seen in the front of the curve."

Here's where the transparency comes in. DBO shareholders know that the ETF will hold that March 2021 contract until about three weeks before it expires, then make that optimization calculation and roll it over, Bloom said.

"So, you have a great deal of transparency as to what your exposure's going to be in DBO, and then you can do the math," he said. "If you buy DBO today and that futures contract is $29 a barrel, you know that if you're above $29 a barrel minus management fees, you have a chance to profit from that. So, it just depends on your expectations and your time frame."

"We think it's the best balance between predictability, transparency and having some sort of dynamic optimization," Bloom said of DBO.

Tom Lydon, CEO of ETF Trends and ETF Database, agreed that investors need to be aware of what they own when they buy shares of commodity ETFs.

"I think a lot of investors were thinking that in buying USO, they may be able to profit from future oil prices when people start driving cars and flying in planes again, but what in fact they bought were people not filling up their tank and a bunch of tankers full of oil sitting off the coast," he said in the same "ETF Edge" interview. "And it didn't translate to them. So, ... you've got to look under the hood."

Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA, echoed that point in the same interview.

"These kinds of products that use futures are more dangerous for investors," Rosenbluth said. "It makes it harder for them to understand what they're actually owning."

Rosenbluth pointed out that although USO is slightly cheaper to own than DBO, with an expense ratio of 73 basis points versus DBO's 78, its underperformance has been notable. Over the past three years, USO has fallen 79% versus DBO's 39% decline.

"So, you really need to understand what's inside the portfolio, how these are different and then determine if these are even appropriate for you and your clients," Rosenbluth said.

USO, the market's largest oil ETF by net assets, fell nearly 3% in Tuesday's session. DBO ended the day slightly lower.

Disclosure: Invesco is the sponsor of CNBC's "ETF Edge."