Events Trader # 15: The truth about commodity ETFs

18th August 2009

The truth about commodity ETFs

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Welcome back.

Today I wanted to talk about exchange traded funds and some the quirks surrounding them. But first, in last week's Events Trader I promised you some more Tier 1 securities tips. We included a general table, but for the purposes of the portfolio, here are the three options I would prefer:

Note the large minimum investment in the HBOS (now owned by Lloyds) bond. I realize that not everyone will want to commit large sums of money to these bonds, but if you are interested, then remember that this refers to a nominal. So for example, if the bonds are trading at 50, that would make the minimum investment around £25,000.

An inconvenient truth about commodity ETFs

As you know I am a big fan of exchange traded funds (ETFs). They allow retail investors to take risks, and gain access to areas that were once restricted to institutions and other specialized investors, without all the hassle of having to have multiple brokerage accounts or deal with margin requirements. They also make it much simpler to take a short position you don't have to borrow stock to do so, for example. So if you see a trend or think that a commodity is going up or down, all you have to do now is to buy the relevant ETF just like a normal share and enjoy the ride!

However there is an intrinsic problem with ETFs, especially those linked to commodities, which you must understand before considering taking out a position.

Commodity ETFs don't always do what you'd expect

You would expect an ETF to rise and fall in tandem with the underlying security, and this is just what happens on a day to day basis over short periods of time.

However, if you want to keep a position open for a few months, you run the risk of significantly underperforming the underlying security, especially if you are going long an ETF which tracks commodities.

To show my point, please look at the graph below. It shows the relative performance of the oil price (the West Texas Intermediate spot price, to be precise) against the United States Oil Fund ETF (USO), which is designed to track the price of oil. As you can see, since the start of the year, USO has underperformed the relevant commodity by around 45%.

This huge gap comes down to the way that commodities are traded, and how ETFs try to track the price of a commodity. I'll explain.

How commodities are traded

Unlike stocks and shares, which trade at a single price determined by supply and demand, commodities are traded over a range of contracts, each for delivery on different dates.

For example, you can buy BP for immediate delivery on the stock market, and you'll pay the price that is quoted at that point in time. But if you want to buy crude oil, you can choose the date at which you can take delivery of the commodity; you can buy oil for delivery next month, in three months' time, in a year's time; or more.

So commodities do not have a single price. Instead they have different prices (forward prices), depending on the time at which you want to take delivery. (These are similar to forward prices on currencies which we used in our risk arb strategies).

In theory there is a simple mathematical formula which determines the price for delivery over the whole spectrum of maturities. This is given by the cost of the spot price (immediate delivery) increased by the prevailing interest rate, plus the cost of storage.

So:

Forward price = Spot price * (1 + prevailing interest rate + cost of storage in percentage terms)

So if the price moves outside this formula, you can arbitrage away the difference.

Here's an example. Say the spot price for crude oil is $30. The six month forward price is $45, interest rates are 10% a year, and storage costs $2 a year.

Under this example, you could buy oil now, take delivery, store it and sell six-month future. Then, after you've stored the oil for six months, you deliver it to the futures buyer. This would make you a tidy profit - you can finance your purchase and storage for six months at a cost of $2.50 ($1.5 in interest and $1 in storage on the $30 purchase price) so you will have a profit of $45-$32.50 = $12.50.

In practice this formula often fails and cannot be arbitraged away. Again, as an example, consider the price of wheat or corn. The spot price today for immediate delivery could be significantly higher than the 6 months price why? Because last year the harvest was bad and the next harvest is expected to be a record one, so grain for immediate delivery is worth more because it's scarce.

Another example is natural gas. Prices for immediate delivery are much lower than the prices for delivery in November - why? Because right now natural gas is not used to produce electricity and heat, whereas in November, the winter will cause a significant increase in the use of energy.

In technical terms, the market is said to be in contango' if the forward price is higher than the corresponding price based on the mathematical relationship with the spot price (natural gas). And you have backwardation' if your forward price is lower than the price predicted by the formula (wheat and corn in our examples).

Once you've grasped this, we can move on to the next step.

How a commodity ETF tracks the underlying security

To replicate the price of a commodity all these ETFs do is to buy the future with the shortest maturity (generally one month). In this way, you have a 100% correlation between the price of the ETF and the price of the underlying security.

What happens when the contract gets close to expiry is also quite simple. The ETF rolls over its position or sells the futures with shorter maturity and buys futures with an extra month's life . (So today you would sell futures for July delivery and buy futures for delivery in August).

So as long as the price stays in line with the mathematical formula, you do not have to worry about anything and you will have perfect tracking. The problems start when the relationship breaks down and the market moves into contango or backwardation. In this case, the ETF will underperform or overperform accordingly, and the amount of the under(over)performance will be equal to the size of the contango or backwardation.

Again let me explain: if crude oil for july Jelivery trades for $30 and the same crude oil trades for august delivery for $40 then your ETF will underperform by 25%. Why? Because it is only able to roll over its position by selling futures for $30 and then buying them back for $40. This also means that your investment will be profitable with a much higher price level for the price of oil.

Of course if you have a market in backwardation, your ETF will overperform significantly as it will be able to roll over at lower prices.

If you're having difficulty imagining this, consider a similar case, only with equities. You buy a stock which you can only keep intra day because you have to close your position every night. The return on your position could underperform or overperform the stock performance over a period of time, and the difference could be quite significant. That's because the stock's volatility is composed of two parts: the intra-day volatility (which you will be able to capture) and the over-night volatility (which you wont be able to capture and which will be the source of the under(over)performance). This is similar to what happens to this ETF they are able to capture the volatility during the month , but if there is a difference in price between the two near contracts you will lose part of the performance .

When it comes to ETFs, size matters

One factor that can significantly increase the underperformance is the size of the ETF with respect to the underlying market. If you had an ETF that was holding 50% of the total net long position in the relevant futures, then you can see that the roll over problem would create significant flows in term of supply and demand, and these would be big enough to disrupt the mathematical relationship between prices for different deliveries.

It sounds incredible but at the moment this is the problem facing the commodities ETFs, where the amount of speculative money invested in them is now a large part of the total market. As you would expect, the Federal Reserve is taking a closer look as some ETFs which are holding a significant portion of futures for near delivery, raising the volatility in the underlying market and disrupting the price information mechanism for industrial and end users who actually rely on the underlying commodities.

The fund industry is waking up to these problems and has introduced ETFs that buy futures over a 12-month timeframe and not the spot delivery only as you can imagine these will not be as volatile as their short term counterparties.

In my view, ETFs that track the spot price are still the best ones, but be aware of these pitfalls as they can significantly increase the risks on your position. Also bear in mind that a backwardation situation will work in your favour, so it is also worth keeping this in mind, as it could lower your entry price.

All in all ETFs are still an asset class worth considering but it's best to be aware of the problems before and not after you have taken a position.

As usual I welcome your questions and suggestions. Please do contact me on eventstrader@f-s-p.co.uk.

Riccardo Marzi

Events Trader

Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Some shares recommended may be denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Please seek independent personal advice if necessary.

Figures are calculated using the closing mid-prices on the date on which shares are first recommended. All gains are gross, and returns will be affected by dividend payments, dealing costs and taxes. Past performance and forecasts are not reliable indicators of future results.

Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors or contributors may have an interest in shares recommended.

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