Look before leaping into commodity ETFs

As much of the world frantically adjusts to rising commodities prices, this might seem like a good time to jump into one of the many commodity-based exchange-traded funds introduced over the past several years.

Not so fast.

Not all commodity-based ETFs are created equal. Some older and single-commodity ETFs, for example, are constructed in ways that prevent them from performing in tandem with their underlying commodities or even with other seemingly comparable funds.

Consider three ETFs that track the price of oil, which increased 15.1% last year.

During the same time period, United States Oil Fund Ticker:(USO), an ETF from United States Commodity Funds LLC, declined by 1%; PowerShares DB Oil Ticker:(DBO), managed by DB Commodity Services LLC, gained 2.4%; and United States 12 Month Oil Ticker:(USL), which also is managed by United States Commodity Funds, gained 6.5%.

Since commodities tend to be highly correlated to inflation and can provide diversification to stocks and bonds, ETF managers have developed and aggressively marketed a steady stream of commodities-based products. However, as illustrated above, investing in commodities through ETFs are not a perfect proxy for buying the commodities themselves.

The reason commodities ETFs don’t track commodity prices precisely is that, with the exception of ETFs investing in precious metals such as gold and silver, which often hold the physical commodities, most ETFs use futures contracts to provide exposure.

In order to prevent having to take physical possession of the commodities when a contract expires, the portfolio is constantly selling and buying futures contracts to maintain the required exposure.

The pricing characteristics of futures contracts are what cause commodities ETFs to veer off from the spot price of their underlying commodities.

During a period when commodities prices are rising, futures contracts — which obligate a buyer to purchase the commodities in the future — keep getting more expensive than the prevailing spot price.

This pricing condition is known as contango. (When futures prices are lower than the spot price, due to expectations of an economic slowdown or a glut of supply, for example, commodities are said to be trading in backwardation.)

“With contango, you are constantly rolling into new contracts that are more expensive than the contracts you just sold, and you have to keep doing it,” said Abraham Bailin, an analyst at Morningstar Inc.

For an ETF such as USO, this can be particularly crushing because it is designed to continue to roll into the next month’s futures contract, which keeps rising in price ahead of the spot price.

CONTROLLING CONTANGO

Some funds take steps to mitigate the effects of contango.

The USL fund, for example, spreads out contango’s impact by owning contracts for each of the next 12 months on a rolling basis.

The DBO fund goes further by applying an optimum-yield strategy by which it rolls its expiring contracts into what it deems to be the most advantageous monthly ones.

“Contango in the commodities markets is a normal state of being, and investors need to understand that it isn’t a bad thing, but they do need to watch it and understand it,” said Tom Lydon, president of Global Trends Investments.

Financial advisers and investors can navigate the negative effects of contango by seeking out more-diversified commodities exposure and funds that use flexible-futures trading strategies.

At $5.5 billion, the PowerShares DB Commodity Index Tracking Fund Ticker:(DBC) is the largest broad-basket commodities ETF on the market, and it has the flexibility to position futures contracts at varying maturities.

Another example of a diversified strategy is the United States Commodity Index Fund Ticker:(USCI). This fund, which was launched in August, allocates to more than a dozen commodities, invests through futures contracts based on both momentum and futures curve diversity.

Van Eck Global in December rolled out its own version of a “contango killer” with the Van Eck CM Commodity Index Fund Ticker:(CMCAX). The mutual fund, which tracks the UBS Bloomberg Constant Maturity Commodity Total Return Index, will hold futures contracts with expirations of between three months and three years.

In short, advisers should be aware of how investing in commodities through ETFs differs from investing in commodities themselves, as well as what the ETF providers are doing to accommodate those differences.

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].