NICK MASSEY
EDMOND — Investing is a difficult business, and choosing the right investment for the short- or long-term can be a daunting task. Imagine the frustration when you get it all right, make the right prediction and still lose money. As my friends in California might say, “That’s a major bummer dude!” That’s what has been happening to some investors using ETFs (Exchange Traded Funds) investing in commodities.
Let’s say you’ve been doing your research and you decided that oil prices have to go higher. You were out recycling newspapers and you saw an old headline that said crude oil is becoming much harder to find and oil production is falling off rapidly at many of the world’s largest fields. You talked to your friends in California and figured out that even the “green people” need some crude oil and their cute little hybrids can’t always run on electricity. And they cannot build enough windmills and solar panels in someone else’s backyard to solve the problem.
So, you decide that oil must go up and buying an ETF holding oil is the answer. Just buy it and sit on it until oil prices go up. Better yet, you don’t have to buy stock in any of those nasty oil companies trying to destroy the planet. Your conscience is clear. If only it were that simple.
ETFs represent a basket of securities that try to replicate a certain index or sector of the market. Some of the advantages are that they’re cheaper than mutual funds and trade like stocks throughout the day. Most ETFs will own what they are trying to replicate. An ETF designed to track the S&P; 500 actually will own all 500 stocks in the S&P; 500 in the same proportions. Give or take a slight tracking error, it basically will perform the same as the index.
Investors looking to buy into the commodities boom of the past year have been aggressively buying ETFs that are designed to track various products, such as gold, silver, oil or natural gas. The most popular gold ETF, the SPDR Gold Shares, has been pretty efficient in tracking the metal’s movement as it has soared to a record high in 2009. This ETF actually owns gold and each share represents ownership of one-tenth of an ounce of gold.
A fairly recent creation, commodity ETFs, have had different issues, and some investors are finding they’re not all their cracked up to be and often have underperformed what they are supposed to be tracking.
The problem is that, unlike a stock or gold ETF, most people actually can’t go out and buy some oil or natural gas and store it in their account. These ETFs try to track the performance of a certain commodity by buying futures contracts on those commodities. But since futures contracts have expiration dates, you can’t just buy one and sit on it until it goes up. As the contracts expire, you constantly have to sell the ones you own just before the expiration and then buy the next contract out. Therein lies the problem.
Occasionally, and especially recently, there has been this little problem called “contango,” which occurs when each successive futures contract trades at a higher price than the current month. This means that you will lose money every time the current contract expires and you have to pay more for the next one month’s contract just to stay in the position.
For example, let’s say you think oil is going up in the next year and you own an ETF like USO. If oil was trading at $70 a barrel in the current futures contract and $71 in the next month’s contract, you would lose $1 each time the ETF had to buy the next month just to stay invested, even though the actual price of oil may not have changed. In a period of months, you could be absolutely right about where you thought oil prices were going but lose money on the trade. If oil prices went down it would be even worse.
Contango exists in the market only sometimes, but when it does, some commodity ETFs have significantly underperformed the goods they are supposed to track. Some of the most popular oil ETFs have sharply trailed oil performance as it has risen some 80 percent this year.
I’m not suggesting here that you should or should not be investing in commodity or currency ETFs. That’s a decision you’ll need to make for yourself. For most people, if you want investment exposure to gold, oil or natural gas, an ETF is definitely preferable to opening a futures account and trading futures on their own. But you still have to do your homework and know what you’re investing in and what the ETF is holding. Thanks for reading.
NICK MASSEY is a financial adviser and owner of Householder Group Financial Advisors in Edmond. He also is a guest analyst on CNBC and Bloomberg. Massey can be reached at www.nickmassey.com. Securities offered through Securities Service Network Inc., member FINRA/SIPC
