Should Retail Investors Avoid Futures Based ETFs? (UNG, USO, HAP, DBC, K, XOM, GG, COP)

My mother’s side of the family owns large tracts of land along the Louisiana and Mississippi border. The area is teeming with wildlife and has been an outdoor paradise for at least five¬†generations. But the real value of this fertile region is the soil itself, where acres of soybeans, peas and other crops grow. In fact, baby-food maker Gerber gets its sweet potatoes from these very fields.

I can understand why my relatives might turn to the futures market to lock in selling prices for their goods — otherwise a sharp drop could be crippling. Likewise, I can see why a company like Kellogg (NYSE:K) uses futures to hedge against costly increases for the tons of grains that go into its cereals.

But I’m not sold on futures-based exchange-traded funds (ETFs) for retail investors like you and me.

Playing a dangerous game
First, they’re speculative wagers, not true investments. There’s no wealth created here, just one party betting the price of a commodity will move up and the other betting it will go down. Futures are a zero-sum game, like poker. And in the futures game, you’re playing against adroit pros.

As the saying goes, “if you can’t spot the patsy at the table, you’re it.”

Studies have shown that the overwhelming majority of futures participants ultimately walk away with less money. But even for skilled investors, there are other reasons to look elsewhere for exposure to commodities.

For starters, the Commodities Futures Trading Commission (CFTC) has stepped up the policing of these funds to prevent less liquid markets from being artificially inflated or deflated. The imposition of strict limits on position sizes has had sweeping repercussions.

Some portfolio managers have had to seek out new markets to get orders in (moving from the Chicago Board of Trade to the Minneapolis Grain Exchange, for example). Others are paying extra for over-the-counter swap contracts. These unusual moves have increased tracking error and hampered performance.

Another unwelcome side effect is the disruption to the creation/redemption mechanism that keeps ETF share prices and portfolio values in balance. At one point last year, the U.S. Natural Gas (NYSE:UNG) fund traded at a +20% premium to its net asset value — forcing investors to pay a hefty markup to the actual commodity price.

The crackdown was so severe that some funds (like PowerShares DB Crude Oil Double Long) have shut down and returned money to shareholders.

The phenomenon that kills many futures ETFs
Regulatory hassles aren’t the main concern. There’s an even more insidious force at work — contango.

Traders refer to this phenomenon when the price of a commodity futures contract is higher than the current spot price. While a traditional fund might hold a stock like Exxon-Mobil (NYSE:XOM) for years, futures contracts are always expiring. That means fund managers must either continually sell and “roll” the proceeds into a further dated contract or take physical possession of billions of dollars worth of gold, or corn, or crude oil — which rarely happens.

But as the table below shows, that often means systematically selling expiring positions low and buying new ones high.

Henry Hub Natural Gas Contracts Price
Sept. 2010 $4.820
Oct. 2010 $4.842
Nov. 2010 $4.998
Dec. 2010 $5.191
Jan. 2010 $5.331

Contango can erode any gains in the underlying commodity over time. And to rub salt in an open wound, opportunistic front-runners know exactly when ETFs must buy and sell, so they capitalize by acting first.

This nimble “pre-rolling” also cuts into the returns of futures funds. Behind closed doors, hedge funds and other arbitrageurs laugh about using this tactic to profit off the “dumb money.” Unwary ETF investors, of course, are the “dumb money.”

All of this is reflected in sub-par returns. Bloomberg just conducted a study of 10 of the largest and most popular commodity futures funds. They found that all 10 have trailed the returns of their respective raw materials since inception.

Perhaps the most egregious offender is the U.S. Oil Fund (NYSE:USO), which has lost over half its value since April 2006 even while crude oil rose +11% during that period. That’s a tough pill to swallow for innocent investors looking to profit from rebounding oil prices.

Better options on the table
None of this is to say that investors should avoid commodities. There are better routes than the volatile futures market.

Funds that physically hold the commodities are one option. But in most cases, I prefer to go right to the source and invest in shares of companies that produce and sell these raw materials. Instead of a paper contract, I have an equity stake in a real business with tangible assets.

Retreating prices aren’t good news for either futures or stock investors, but at least the companies will still usually manage to turn a profit. For example, Goldcorp (NYSE:GG) can get gold from the ground to the market for just $363 an ounce — versus a current selling price of around $1,200.

If prices remain flat, investors will still get a reliable dividend yield of 4% from companies like ConocoPhillips (NYSE:COP). The counter-party to your futures contract won’t be so generous.

Finally, if prices rise, producers have operating leverage that pushes most of the incremental gains right to the bottom line. Goldcorp just turned a +30% increase in gold selling prices into a +60% increase in quarterly operating profits.

So in an up market, commodity stocks usually outperform the commodity itself by a wide margin. Since November 2008, our position in Market Vectors Hard Assets Producers (NYSE: HAP) has already delivered a gain of +36% — while all-futures substitute PowerShares DB Commodity (NYSE: DBC) has dropped -5.1%.

With all this in mind, think twice before falling prey to a sales pitch for the latest futures fund to hit the market. Having new options is great — but that doesn’t mean you have to sample everything.

Written By Nathan Slaughter From Street Authority

Disclosure: Neither Nathan Slaughter nor StreetAuthority, LLC hold positions in any securities mentioned in this article.
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