How Not to Get Burned By Commodity ETFs

July 23rd at 12:00pm by Tom Lydon

With any investment, you need to know the details of what you’re investing in. Just because a commodity exchange traded fund (ETF) is supposed to track the spot price of, say, oil doesn’t mean it will follow it. Over the past few years, many main street investors had to learn that the hard way.

Bloomberg News reports that a 68-year-old psychologist in Napa, California saw his nest egg shrink by 50% as his investments in stock and commodity ETFs soured during the recession.

Gordon Wolf – the psychologist- had expected commodities to offer a hedge against equity losses. Instead, everything fell in tandem.

But even as his portfolio dwindled, Wolf was certain that with oil at $34 a barrel, he was looking at an opportunity of a lifetime. So, he called his broker to buy him $10,000 worth of United States Oil Fund (NYSEArca: USO). [Are Oil Services ETFs Undervalued?]

Over the next month, Wolf watched as the price of oil rose 7.4% while USO fell by that same amount. Why the discrepancy?

The culprit was contango, a situation where the future price of a commodity is more expensive than a near-term one. [Understanding Contango.]

It works like this: When the futures contracts that commodity funds own are about to expire, they’re sold and replaced with new ones. If prices are in contango, then when they buy the more expensive contracts, they lose money.

Contracts have to be sold as they near expiration, otherwise you’re looking at the delivery of many barrels of oil.

But it’s not just single-commodity funds that may experience this effect. It was also seen in the Standard & Poor’s Goldman Sachs Commodity Index, which tracks 24 raw materials. During one period in May, fund managers sold their expiring contracts for $75.67 while buying futures contracts at $79.68. But by July, the futures contracts had fallen back to $75.43.

Looking at 10 well-known commodity ETFs based on futures contracts, all 10 have trailed the performance of their underlying raw materials. Since April 2006, USO has lost 50% even while crude oil has climbed 11%.

If you are interested in investing in commodities, but are concerned about this issue, here are some things you can do:

  • If you’re going to invest in commodity ETFs that hold futures, do some research first to find out if prices are, in fact, in contango.
  • Read the prospectus to find out how the fund works, or give the provider a call and ask. You can find the prospectus for any ETF by visiting the ETF Resume:

ETF Resume, Commodity ETFs

  • If prices are in contango, look at some of the available 12-month funds, which invest in futures through the whole year, and not just the front months. This mitigates the effect of contango. United States 12 Month Oil (NYSEArca: USL) is down 5.8% year-to-date vs. USO’s 9.8% loss.
  • You can look at ETFs that track commodity services companies such as SPDR S&P Oil & Gas Equipment & Services (NYSEArca: XES). [7 Commodity ETFs You Should Know.]

For more stories on commodities, visit our commodity category.

Sumin Kim contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.