Commodities ETFs' Achilles Heel

Will McClatchy,
February 19, 2011

The idea that commodities can protect investors from inflation or the volatility of stocks is popular and based on crises of the 1970s and 1980s where commodities rose with inflation and moved inversely with stock prices. In more recent years the pattern has broken down, but the idea is worth consideringImplementing this idea through ETFs, however, is problematic because they often trail commodity spot prices, sometimes badly. Since it is too costly and complicated to store physical commodities (gold is an exception), most funds turn to short-term futures contracts to approximate spot prices. That is where the trouble begins.Funds tracking oil, metals or grains "roll" contracts or sell them as they approach expiration and buy contracts further out in time. In most commodities markets, roll has a small loss because next month's futures contracts are a tad more expensive than this month's (a condition called contango). A small loss can be justified as the convenience of not having to physically store goods. But all-too-often contango gets out of hand.Here is where commodity ETFs are part of the problem. They exacerbate contango with the following practices:

  • -an excessively large fund compared to its futures market
  • -regular rolling over of the shortest contracts
  • -predictable trade dates
  • -tight windows for trading

Professional Wall St. traders have made a tidy living picking certain ETFs apart by jumping ahead of them and shorting oil futures which ETFs have scheduled to sell and by buying oil futures which ETFs have scheduled to buy. ETFs dutifully hand the traders virtually riskless profits which should have gone to investors.United States Oil Fund (NYSEArca:USO - News) was the epitome of this. During the oil price gyrations of 2008 and 2009 it rolled over hundreds of millions of dollars in contracts each month in a small number of known trading days. Wall Street traders surged to punish USO and extract virtually risk-free returns. When oil spiked and investors should have made a killing, USO lagged spot returns by double digits. This is an asset class that demands nimble managers.The Commodities Futures Trading Commission investigated potential market manipulation by Wall St. traders, but in reality the fault lay with USO trading practices. The fund was too eager to track spot oil prices in a formulaic way. USO revised its policies and now trades over multiple days and is faring better. Many funds have changed their practices, which we applaud. Best practices include an expanded roll window of many days or even weeks, the flexibility to skip over an expensive month to lengthier contracts, taking physical delivery or entering into private contracts with commodity producers off-market. All of this makes a fund less predictable and less likely to be poached.USO's sister ETF, United States 12 Month Oil Fund (NYSEArca:USL - News), for instance, diversifies into contracts going out one year. USL has typically tracked spot oil prices better than USO, even though that is not its stated goal. A little ingenuity and determination is all that is needed for an ETF to avoid getting picked apart by professional traders in the commodities arena.Most of the worst ETF-driven contango nightmares are over, and investors should not be upset at a modest convenience contango cost, but what concerns us is the sheer volume of passive investors who have piled into futures. It is not just ETFs but also pension funds and investment advisors who are allocating 5% to 15% of portfolios to commodities. They are coming to dominate and distort many futures markets. Not only are they likely to push up spot prices artificially, but they are likely to drive contango higher on a permanent basis.Coupled with recent years' lack of correlation with inflation or inverse correlation with equities, we view futures-based commodity ETFs as unsuitable for broad-based, long-term passive investing. These ETFs are more suitable for traders with a short-term focus or insight into particular markets. They can shield themselves from inefficiencies with the following actions:

  • -avoid any big ETF (holding 5% of a type of futures contract)
  • -look for flexibility of trading clearly stated in its prospectus
  • -watch for contango and avoid when high

Co-founder of, author of two books on investing, and founder of, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.