The Key to Investing in a Futures Backed ETF

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As the global equity markets become more and more integrated thanks to globalization, investors have been looking into other asset classes for diversification benefits. In this process, they often tend to overlook the crucial aspects of investing in these products and most of the time end up getting burned.

Commodities are one such asset class that provide a reasonable amount of diversification from equities. However, they might also exhibit strong positive correlation depending upon various macroeconomic developments.

For example, equities and commodities both surged on the Federal Reserve’s announcement of a third round of quantitative easing, the QE3.

Nevertheless, commodity ETFs are the easiest way of gaining exposure to the natural resource space. However, most of the products provide an exposure in the underlying commodity via futures backed route.

This is in contrast to those that actually invest in the commodity and hold it securely—like with what we see in the gold and silver markets. While this might seem like a minor detail,  it can have serious consequences on the profit (or loss) incurred by the investors (read Volatility ETFs: Three Factors Investors Must Know).

The effect of Contango is by far the single biggest factor that investors must consider before investing in any futures backed product. The futures curve under ordinary circumstances will be upward rising.

However, in a market with contango, the front months’ contracts are less expensive than those in the far months. Most of these ETPs will therefore roll over positions from the front month contracts to one in the far month (i.e. sell high, buy higher) in order to avoid physical delivery. This causes an ETP to lose money every time it rolls over its position (see Natural Gas ETFs: Futures vs. Equities).

While contango is generally associated with a situation of oversupply and falling spot prices of the underlying commodity, surprisingly, the effect of contango can eat up fund return even if the underlying commodity has ended on a positive note for the period of time under consideration. To highlight this effect, two futures backed Energy Commodity ETFs have been chosen.

The PowerShares DB Oil ETF (DBO) and the United States Oil ETF (USO) are two such ETFs which track Oil futures and employ the roll over methodology to track the performance of spot Oil prices. And needless to say, these are susceptible to contango.

These two Oil ETFs provide a pure play in the oil segment in contrast to the Energy Select Sector SPDR ETF (XLE) which tracks the stock market performance of companies engaged from the broader energy sector of the U.S equity markets. Although they somewhat track the same segment, their performance trends are very different.

In fact, a closer analysis suggests that the pure play ETFs i.e. USO and DBO have a very strong correlation with the performance of crude oil as measured by WTI Crude prices. In fact the chart below goes to show the extent of the strong correlation of the futures backed ETFs in contrast to the equity ETF with WTI Crude (read Time to Return to Uranium ETFs?).

As we can clearly see, the correlation between the futures backed ETF and WTI Crude has seldom dropped below 80%. In fact on the contrary, most of the time their correlation tends to exceed 90%. However, when it comes to the performance evaluation of the ETPs compared to WTI crude, a very interesting fact is revealed.

In the trailing one year time frame, WTI Crude has been beaten down a bit, starting at $104/bbl, moving widely, but finishing the time frame right around $94/bbl or a roughly 10% loss. However, we have not seen the same thing in the oil or energy ETF market by any means.

For the same time frame XLE has returned around 11.7%, however, DBO and USO have slumped by 13.6% and 15.5% respectively.

This has happened primarily due to the recent technological developments which have increased the extraction and production of energy products as well as weak macroeconomic cues which have decreased the demand for industrials fuels. This situation has paved the way for a classic case of oversupply for the commodity which is the primary reason for contango across the futures curve (see Best ETFs to Start 2013).

However, it is worthwhile to note that the reason for a higher loss in USO compared to DBO is the fact that USO seeks to roll over positions on a daily basis which magnifies the effect of contango. DBO also uses a methodology which seeks to minimize the effect of contango when the contracts are rolled over.

This is reflected in the expense ratios for these two funds where the slightly actively managed DBO charges 0.79% compared to USO charging 45 basis points annually in fees and expenses. However, it is also worthwhile to point out that the strategy for DBO has gone a long way in reducing losses for its investors (read Three Surging ETFs with Strong Momentum).

Given the above effects of contango in returns for the futures backed ETPs, it might well be the single biggest factor to consider for investors seeking the futures route to gain access in the underlying asset class, and especially with ETFs.

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