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 January 2010 Not Created Equal Commodity ETFs Aren't as Simple as They Seem -- and It Matters
But commodities truly are a different asset class. You can't buy crude oil like a stock or bond. It's an asset that must be stored and processed to attain its highest value. While it's possible to derivatively participate in the oil market by purchasing shares in integrated oil or exploration and development (E&D) companies, they'll trade a lot more like other equities, and won't add the same level of diversification to your portfolio. Also, because they aren't pure plays on the crude oil market, they won't provide the same appreciation potential as the commodity itself. Short of actually owing and trading barrels of oil, the crude futures market is the best alternative. Futures contracts give the buyer (or seller) the opportunity to buy (or sell) a commodity now for delivery at a specified time in the future. In essence, they allow participants in the commodity market to buy or sell today what they anticipate they will buy or sell in the future. For example, if a drilling company believes oil prices will fall over the next six months, it can sell today for delivery in six months the inventory it will then have on hand. This allows it to lock in today's price regardless of how it fluctuates over the next six months. Buyers who expect prices to rise in the next six months would be willing to purchase these contracts. Most investors don't want to physically take ownership of barrels of crude oil if even for just a short period of time. But that doesn't prohibit them from using futures as a way to share in oil market gains. In reality, most futures positions are closed in the weeks prior to expiration, allowing investors to reap gains without ever touching the first barrel. But most investors don't trade futures -- or even want to. By their very nature, futures involve leverage and margin trading. Unlike common stocks that are considered to have an infinite duration, futures contracts have a specific expiration date placing a time limit on the bet. Not only must the investor be correct about the commodity's direction, he or she must correctly anticipate the timing as well. This additional risk is enough to keep many investors from seriously considering trading futures. Now there's another alternative, exchange traded funds (ETFs). As is often the case, when crude oil started its dramatic rise several years ago, crude oil ETFs quickly appeared. Rather than investing in energy companies, they give investors the opportunity to participate in the oil market through a portfolio of futures by simply purchasing one listed ETF on a major stock exchange. In other words, an easy and cost-effective way to share crude oil's gains.
Under the Hood Although some ETFs for gold and silver actually take ownership of their underlying commodity, crude ETFs focus on futures. Just as individual investors can capture commodity performance through the purchase and sale of futures contracts, oil ETFs can pool investor funds and do the same thing. Because crude futures are priced to represent anticipated values of oil at various points in the future, a contract expiring in the next month will be valued differently than one expire in twelve or twenty-four months. This difference coupled with the ETF's purchase policy determines how closely it will follow current (referred to as "spot") oil prices.
Because of inflation, commodity prices tend to rise over time. Just as the bond market reflects this through higher yields for longer term maturities, the futures market typically prices contracts expiring in the near term below those with longer expirations. Commodity traders refer to this pricing pattern as "contango". On the other hand, when prices are expected to fall, the pattern is reversed. When near term contracts are priced higher than longer expirations, the market is said to be in "backwardation". What a wonderful term. Consider Barclays Capital's iPath S&P GSCI Crude Oil Total Return Index (OIL) that purchases one-month contracts and sells them a few days before they expire. Proceeds are then used to buy the next month's contract. It's a straightforward approach, but performance suffers when the commodity market is in contango because the near month contracts that are sold are always cheaper than those of the next month. In other words, each month the near term contract is sold for x, but the next month's is purchased for x+y. Regardless of the value of y, it always represents a loss even though crude prices have risen throughout the period. (It should be noted that OIL is actually an ETN, an exchange traded note rather than an exchange traded fund. Although the structure and a few of the tax ramifications differ, the ETN can be purchased like an ETF on the New York Stock Exchange. Comparable ETFs such as the United States Oil Fund (USO), the most popular crude ETF, use the same strategy.) An alternative strategy, like the one employed by the PowerShares DB Oil Fund (DBO), attempts to minimize losses when rolling over expiring contracts when the market is in contango. Rather than mechanically purchasing the next month's contract, DBO buys the one that over the course of its lifetime minimizes the monthly loss. To see how this work, consider a situation where the next months contract is $5 more expensive than the expiring one. A rollover here would lock in a $5 loss. On the other hand, if a contract three months out costs $12 -- fully more than twice the price of the next month's -- it would be purchased because its monthly loss is only $4 ($12/3 months). This process doesn't completely negate the effect of contango, yet it does minimize it.
The Results
Neither the ETN nor the ETF have been able to keep up with the gains of the spot prices (+42%). As expected, the Barclays ETN fared the worst, losing 18% over the twelve months. The PowerShares ETF added 22% yet was still well behind the spot price results. Investors using either exchange traded security had to be disappointed if they expected to closely track the commodity. In fact, they would have actually come out about a half point ahead on price appreciation if they had simply invested in an S&P 500 index fund -- and that's not including any dividends it would have paid. Sometimes plain vanilla ends up being more effective than even the most clever alternatives. This is a case in point. The difference becomes even more striking when adjusted for risk. The standard deviation for the S&P 500 was 27.73%. This is no small number, but it's certainly preferable to the Barclay ETN's 45.02% or the PowerShares ETF's 42.63%. You'd expect commodities to carry additional risk over an unmanaged index with five hundred components, but you'd also expect higher return to compensate for it. This is exactly what happened with the spot prices that carried the most risk (standard deviation of 59.07%) but also roughly doubled the S&P's return. Of course twelve months is a very short period to use to draw any meaningful conclusions. Unfortunately, commodity ETFs haven't been in existence for very long. Looking at the twenty-three months from January 1, 2008 through November 30, 2009, the common period for the exchange traded securities, the results aren't much different. In this case, each series was in negative territory, but once again, the Barclays ETN posted the biggest loss (33%) versus losses of 11% for the PowerShares ETF and the S&P GSCI Crude Oil Spot price series. The S&P 500 lost 14% on a price appreciation basis.
About that Diversification To be fair, it is important to point out that the past two years were a period of market crisis when all correlations tend to converge. Even so, the S&P 500's longer term correlations with Treasuries, corporate bonds, and REITs were all much lower, the first two were actually negative. So even over the long term, crude oil funds didn't deliver the expected additional diversification. Without further research, it's difficult to explain why this is the case, particularly given that both OIL and DBO had such high correlations with crude spot prices. One reason that is often cited points to the fact that ETFs and ETNs are bought and sold on stock exchanges and trade similarly to stocks. In this case though, the correlations with the S&P 500 while significant, still weren't that high. Over the past twenty-three months, spot oil itself sported a 0.5036 correlation with the S&P 500 price appreciation series, suggesting oil itself isn't a particularly good diversifier.
Learn the Details As both the Barclays ETN and PowerShares ETF demonstrated last year, oil prices can soar, but they won't necessarily capture the returns. If you're looking to share in crude's rise, they can help out, but if you're looking to replicate it, you're bound to be disappointed. They won't provide significant diversification, either. If you already have a well diversified portfolio of stocks and bonds, they may offer a little help, but don't expect them to negate the risk of another financial market meltdown. In fact, traditional investments such as Treasuries and corporate bonds may prove to be a better source of diversification. Because of this, it might be more beneficial to assure your portfolio is well diversified by adding additional stocks and/or bonds before considering adding commodity funds. But if you do decide to take the plunge, take the time to understand what you're buying before you put your money down. As the past year so clearly demonstrated, all crude oil exchange traded funds and notes are not the same. Divergence of returns -- as illustrated by OIL and DBO -- strongly suggest their strategies differ. It's critical to understand them in order to make an informed decision. Don't just focus on past history, either. As mentioned above, the oil market has been in contango for most of the past two years. Focusing solely on that would be tantamount to making equity purchase decisions based on the exceedingly bullish performance from 1998-1999. Just as stocks eventually reverse course and suffer though bear markets, commodities will eventually experience a period of backwardation where near term contracts are priced higher than longer term ones. In this situation, OIL's policy of rolling over near term contracts will consistently generate profits while DBO's more managed approach could result in losses. You've got to consider this even if the market's currently in contango, because it won't always be. We've always been in favor of diversification across holdings and asset classes, but we're also big fans of understanding what you own. This is a case where the latter is much more important than the former. Search this site! Just enter you key word or words:
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FTER OIL PRICES SPIKED IN 2008 and held a substantial part of their gains last year, many investors considered investing in crude. After all, if you're going to have to pay more at the pump, you may as well share in the profits. In addition, many sought the added diversification from adding another asset class to their portfolios.
