
Amber Waves of Pain (Do Not Buy Commodity ETFs) - leelin
http://www.businessweek.com/magazine/content/10_31/b4189050970461.htm
======
perkoff
It does not have anything to do with contango.

In a paper called "Facts and Fantasies about Commodity Futures" (Yale, 2004),
Gorton and Rouwenhorst came to the following conclusion after studying 45
years of data on a wide array of commodities:

\- "commodities that have been more backwardated (by the second definition)
have not earned larger historical returns"

\- "During our sample period, this commodity futures risk premium has been
equal in size to the historical risk premium of stocks (the equity premium),
and has exceeded the risk premium of bonds."

George Rahal wrote a paper recently that also showed that
contango/backwardation did not have any affect on commoditiy returns:
[http://www.hardassetsinvestor.com/features-and-
interviews/1/...](http://www.hardassetsinvestor.com/features-and-
interviews/1/2072-george-rahal-contango-has-no-effect-on-commodity-
returns.html)

"The other thing is, commodities are an artifact of futures, so they appear to
have more volatility in the front month than in the back. Volatility is not
the friend of a long-term index-type investor. So an index that avoids the
front month is ideal."

There are some commodity ETFs that are not suitable for long term investors
though. UNG, which tracks US Natural Gas, generally have bad returns. This is
mostly due to the frequent turnover, since it holds the front month futures.

------
_delirium
The biggest gap in expectations seems to be that people think they're buying a
share in some sort of underlying commodity, as opposed to a rolling series of
1-month futures. It'd be as if S&P 500 index ETFs, instead of holding a
weighted index of the S&P 500 stocks, were just buying and rolling over SPY
options.

Any particular reason they're 1-month contracts, though? It seems the
treading-water aspect would be greatly reduced if these funds could trade,
say, 1-year futures. Do longer-dated futures just not exist, or at least not
exist in markets that are liquid enough?

~~~
hristov
The problem with one year futures is that they do not track the spot price of
oil as well. The whole purpose of an oil ETF is for it to give you the ability
to buy or sell a bunch of oil at any time without having to deal with the
actual oil. Thus, the value of an ETF should track the current (spot) price of
oil.

But if the fund buys one year contracts, their costs will not reflect the
current price but what people believe the price will be at the end of the
year. So the ETF will be mis-priced in relation to the current price. I think
that is why they try to buy contracts that are relatively short, because they
track the current price better.

~~~
Confusion

      The whole purpose of an oil ETF is for it to give you the
      ability to buy or sell a bunch of oil at any time without
      having to deal with the actual oil.
    

If that's the purpose, then they were flawed when conceived, because, as the
article shows, the ETF´s cannot abstract from the costs involved with dealing
with the actual oil.

------
hristov
This is the reality of Wall Street, any time you tie your self to a certain
predictable future behaviour, people will figure that out and figure out a way
to exploit you.

Those exchange traded funds screwed themselves because they committed
themselves to buying contracts at a specific time. So other traders knew about
it and made sure the prices of the contracts at that time were extra high.

And it does not seem like there is a good answer. On one hand you can have the
ETFs stop their requirements to buy or sell at a particular time. Thus you
would entrust the managers of those funds to find good times to buy and/or
sell. But then again can you trust the managers? There is a huge incentive for
the managers to take bribes from another trader to buy or sell at times that
are bad for the fund but good for the other trader. Or, maybe the managers
simply are not very good and choose bad times. In a way you have an agency
problem, and ETFs were invented in order to remove any agency issues. That is,
the whole philosophy behind ETFs is for them to be automatic so you do not
have to trust the judgement of some manager to buy them.

I think the only answer is for investors is to buy the contracts directly and
not to go through ETFs. Of course that is a bit dangerous, because if you do
not clear your position in a timely manner, you always risk somebody actually
delivering a thousand barrels of oil on your front lawn, but hey that is a
risk you have to take if you want to be commodities investor.

~~~
leelin
This is a very interesting problem. Basically the algorithm for when to roll
needs to be:

1.) Random and hard to predict before-the-fact

2.) Totally verifiable after-the-fact by the public (or by an uninterested
authority the public trusts)

That means a randomized algorithm whose seed is something the ETF manager
knows before the general public, but which everyone else can verify once they
publicize the info.

Quick brainstorming:

1.) They seed based on a hash of their total AUM or PNL on a certain date,
down to the penny, which is almost impossible for outsider's to predict but
which they know internally and can publicize in the next quarterly statement.

2.) They tell the SEC a list of state-run lotteries in secret, then the seed
is the winning lottery number on a particular night. The public can never know
which lottery is the one that matters until after-the-fact.

3.) Seed based off a hash of the concatenation of every employee's birthday or
social security number, which is never public, but if there was ever a serious
investigation or audit, they could verify to authorities that they followed
the rules.

------
leelin
Quick summary:

We're all taught that receiving $1 tomorrow is better than receiving $1 a year
from tomorrow. Even if you can't use the $1 tomorrow, someone else likely can,
and capital markets make it easy to get your money to them. That's why the
interest rate yield curve is normally upward sloping, and the discount factor
curve is almost always monotonic.

[http://www.cmegroup.com/trading/interest-rates/us-
treasury/2...](http://www.cmegroup.com/trading/interest-rates/us-
treasury/2-year-us-treasury-note.html) (for the purists, I know there is a lot
else going on in the treasury bond future curve, but it's hard to find a good
DF curve)

In commodities, however, receiving a barrel of crude oil tomorrow is not
necessarily more valuable than receiving a barrel a few months from now. If
there is more oil available than people who can readily use it, then receiving
crude oil tomorrow means storing it and potentially transporting it in the
future. It's quite common for oil to be delivered next month to be cheaper
than oil to be delivered the following month, and so on.

[http://www.cmegroup.com/trading/energy/crude-oil/light-
sweet...](http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-
crude.html)

Commodity ETFs at first attempted to buy a stake in the underlying commodity.
It worked for easy to store items like gold or cash-equivalents. When they
tried to do the same for oil or natural gas, it was too costly or too big a
headache.

The work-around was to trade futures contracts for each of the commodities,
and avoid ever taking physical delivery of millions of barrels of oil by
selling contracts shortly before their delivery date and buying new contracts
with further away delivery dates.

Unfortunately, the futures contracts already implicitly include the cost of
storage and the investor aversion to taking physical delivery, making the ETF
manager pay a cost every time they move from almost-expiring contracts to
longer-dated contracts.

The rest of the article explains anecdotes about how a few large players take
advantage of the situation. Some people can predict when large ETFs need to
roll their contracts and profit by front-running. Others invest in efficient
storage and transporting frameworks in order to take physical delivery and
sell at a profit in the future.

My questions:

Why not minimize the front-running problem by making the dates you roll harder
to predict? Instead of rolling the front month every month, why not include
some basket of CL1 thru CL12 and find opportune times to roll? Once these ETFs
got popular, why not invest in some of the storage infrastructure and charge a
slightly higher fee but give much better tracking to investors?

~~~
tansey
Good summary.

> Why not minimize the front-running problem by making the dates you roll
> harder to predict? Instead of rolling the front month every month, why not
> include some basket of CL1 thru CL12 and find opportune times to roll?

While this is being done by some funds, I would think volume is an issue. I'm
not very familiar with non-equity futures, so I could be wrong, but typically
the front contract is the only one with significant volume for large funds.
That is, until the contract gets near expiration, at which point volume slowly
creeps up in the next contract.

However, the article mentions that at one point UNO was 86% of the natural gas
market for the near contract. To me, it seems almost negligent if you're the
fund manager to allow it to swell to that size. No wonder arbitrage funds are
popping up to pick them off.

> Once these ETFs got popular, why not invest in some of the storage
> infrastructure and charge a slightly higher fee but give much better
> tracking to investors?

From the way the article describes the major banks, it seems like they're
already doing something similar to this. I wonder if they offer ETFs with this
structure.

The one thing I can't understand is why the CTFC thinks it should be trying to
protect these ETFs from getting pre-rolled. There is nothing illegal going on
here, it's just dumb, slow-moving fund managers getting taken advantage of by
smart, nimble traders. An ETF which poorly tracks its underlying commodity's
spot price should simply go out of business because people stop investing in
it.

------
joubert
This also illustrates the important point of only ever investing in stuff if
you _understand_ them and how they're packaged.

------
tocomment
So it sounds like these ETFs aren't a good investment. Do you guys have any
recommendations for good investments that also offer reasonable protection
from inflation?

It's a shame about these oil ETFs being no good. It seems like the perfect
investment as I can't imagine the price of oil ever going down in the long
term.

~~~
binaryfinery
It does not seem like a perfect investment. The only way it can seem like a
perfect investment is if you do not investigate what it is. How many other of
your investments are "perfect" do you think? And why would you be worried
about inflation?

~~~
lsc
because it is in the interest of perhaps the majority of Americans to have
inflation, and because it seems that the fed is trying to generate inflation.

On the other hand, there are some pretty big deflationary forces (like, say,
bad loans) at work here, so being /certain/ of inflation is probably a bad
idea, but I can see why a person my worry that we might have inflation.

~~~
binaryfinery
I don't think the Fed is trying to generate inflation, simply because if they
wanted to they could. If you look at their own reports, however, we clearly
don't have inflation and aren't going to for a long time. About 20 trillion
dollars have been wiped out of the money supply. The trillion dollars of
printing so far is like hoping taking a piss will turn a tsunami. And most of
that trillion dollars has been taken by the banks and put right back into the
federal reserve system. Check out banks' reserves. Any money the Fed has given
out hasn't affected spending in any way.

There is a way they could get inflation going: if the _government_ prints
money (i.e. not borrows printed money) and gives it away to people, e.g. by
lowering taxes a lot. But they can't. And we all know they cant.

~~~
lsc
hell, the last Bush sent everyone a cheque for three hundred bucks. (and the
liberals complained... even though it was the most progressive tax cut of my
lifetime. Not the whole package, of course, but mailing everyone the same flat
three hundred bucks. For me, that was a pretty small tax cut... but for some
people that was almost a 100% tax cut.) why couldn't that happen again with
larger cheques? The republicans are no longer restraining it; naked Keynesisim
seems to be the order of the day, at least when the economy is in the toilet.

If we see significant deflation, the government /will/ take action to prevent
it. What and how effective that action will be is anybody's guess... my
understanding, though, was that Ben Bernanke has mentioned this ability to
print money to avoid inflation before.

Anyhow... I'm not saying that we will see big inflation, just that it seems
quite reasonable for a layman to see a /chance/ that we will have inflation at
some point in the near future. hedging some against that chance, I think, is a
rational thing to do.

------
heyrhett
It is possible for the reverse of contango to happen (called backwardian)
where the etf would actually go up in the short term while the commodity stays
flat.

Ultimately though, the reason why contango has to win in the long run is that
there is a real cost associated with holding oil. Contango should be a lot
cheaper with gold, since it's cheaper to store gold.

The amount you might lose to contango in an ETF is probably a lot cheaper than
if you tried to horde a bunch of oil in a tank on your property anyway, so
it's not really a terrible investment.

Moral of the story: don't invest in instruments you don't understand.

------
zach
There was a very clever hack that econ professor Robert Shiller (of housing-
market fame) came up with to avoid having to deal with secondary markets like
futures trading.

It goes like this: there are a pair of ETFs, with equal amounts of outstanding
shares. Each share in an ETF represents one portion of a claim on $120 (for
example). But the exact amount that each of the two is entitled to seesaws
based on some external variable, such as the future market for crude oil. So
if a barrel of crude is priced at $40, one fund (the "up" ETF) will be valued
at $40 per share and its paired fund (the "down" ETF) will be valued at $80 a
share. The shares come into existence in pairs and can only be redeemed at the
end of the fund's lifetime.

As you can see, this offers a nice solution to the horrendous problems seen in
the article. However, when this idea was actually turned into a real product
(MacroShares), it ran into real-world problems again and again.

Their first oil funds had to be closed early because it was actually based on
that $120 figure -- and when the price of oil shot up close to that level, it
triggered an automatic termination. And when they got their $200-a-barrel-max
follow-on running, it had lost a lot of the momentum of the earlier funds.

But their major problem was that their complexity was all in full view of the
traders, and people found it hard to really understand. Because even though
its current asset value was based on the price of oil on a commodity exchange,
the "up" version often had a very large premium over that price (and the
"down" ETF a discount). That was the effect of contango -- people were
figuring in the rising future value of the oil. So in fact, it was actually
_providing a more accurate price than the commodity market_ for the storage-
free value of a barrel of oil!

Now, that's fascinating and all, but investors wanted a product based on the
commodity market value, so it made things annoyingly obscure. Add to that the
really complex situation when factoring in the possibility of early
termination -- in which case the future price doesn't matter at all because
the funds are paid off according to the commodity price at the point of
termination -- and things just got to be too much.

MacroShares ended up closing their oil funds in the middle of last year,
replacing them with a pair of US city real estate index (yes, the Case-Shiller
index) ETFs which seemed interesting but were _wildly_ unpopular. It looks
pretty bad for the concept right now, but they are probably just waiting in
the wings for the next opportunity since they can provide a way to invest in
things that otherwise would never be feasible.

------
sabj
This is a fascinating article, and a good summary about contango -- a quite
fascinating topic that has been exploited for great profit and success to
those with large amounts of capital and savvy to deploy in the last decade,
especially around the various times of great volatility.

What I _don't_ appreciate is an article on the web artificially sliced into 7
pieces for more pageviews :( Thanks BusinessWeek... _"print article"_

------
heatdeath
I've held GSG for a year or so and wondered why it wasn't gaining while gold,
oil, and everything else was going up. Is there any way to invest in oil using
a standard brokerage account? Doesn't seem like it.

