To call the recent market for oil “volatile” would hardly do justice to this much-sought-after commodity. The recent roller coaster of global oil demand has left many investors struggling for understanding and set off a ripple effect in the broader market. At the same time, many market participants are reexamining oil strategies that could reap rewards from volatile prices while offering arbitrage opportunities from the sometimes-senseless intraday price movement. Launched in early July 2008, the Macroshares Oil Up (UOY) and Oil Down (DOY) ETFs offer investors long and short strategies for oil and have reflected recent swings in their respective charts. While UOY and DOY have not met substantial enough volume levels to make them appropriate for most investors, their evolutions and recent trading patterns serve as excellent lessons in the viability of certain ETF products and the emotional nature of ETF trading in a turbulent marketplace.
Macroshares applies a unique approach to ETF investing that inextricably ties the pricing of long and short ETF pairs. Unlike most ETFs, where investors synthetically own baskets of underlying securities, Macroshares pairs are composed of Treasuries. Depending on the performance of the index that the pair is tracking, funds move from the long fund to the short fund as the price of the index fluctuates. This way, capital is fluidly transferred from one strategy to the other, as dictated by the performance and set benchmarks of the funds. Currently, UOY and DOY swing about a $100-per-barrel benchmark for oil, a benchmark set only recently in response to the seemingly distant oil spike through summer ’08.
UOY and DOY are not Macroshares’ first attempts at long and short oil strategies. When the products were first launched, the fulcrum—or reference price—between the two funds was set at $60 per barrel—a benchmark that ultimately closed down the funds in early 2008, when oil spiked and the $60 midpoint seemed like an unrealistic and distant memory. As oil doubled this benchmark, the abrupt flow of assets from the short strategy into the long strategy effectively bankrupted one half of the pair. Unable to sustain the pair’s symbiotic relationship, Macroshares shelved both products when oil reached the funds’ trigger price of $111. When oil shot past $111, assets within the funds were liquidated, effectively shutting down the funds and prompting Macroshares to go back to the drawing board for a new fund benchmark. With the current reference price of $100 per barrel, oil futures would have to trade above $185 for three consecutive days before the funds would be liquidated once again.
Assets flow between UOY and DOY based on a system of “pledges” dictated by the price of oil. “Oil down” assets are placed into an “oil down” trust, while “oil up” assets are placed in an “oil up” trust composed of Treasuries and short-term securities. A predetermined formula pledges the assets of one trust to the other trust in correspondence with the changing dollar value of NYMEX front month light sweet crude oil futures contracts. Because both funds were originally valued at $25—one-quarter of the funds’ $100 reference price—if the price of oil falls by $20 a barrel, UOY will pledge $5 to DOY, transferring funds from the long strategy to the short strategy.
While the popularity of long and short ETF strategies will make DOY and UOY particularly appealing to investors captivated by recent volatility in oil prices, the benchmarks and limitations placed on them by Macroshares could be unsettling to most investors. Macroshares has proven its willingness to reconfigure the funds when forced to by pre-existing benchmarks, but the uncertainty of current oil prices could trigger these liquidations at an increasing frequency. These liquidations present up-front uncertainty not found in other popular oil ETFs such as USO, and will dictate more attention from already weary investors. DOY and UOY’s new $100 benchmark was designed with an eye toward upward momentum, but now investors will have to watch the downside with equal concern.
With the looming possibility of liquidation and lack of intraday trading volume, DOY and UOY might be best observed from the sidelines, for the time being. Long and short strategies have grown an increasing amount of traction in recent months, but DOY and UOY differ intrinsically from other strategies that may seem similar on the surface. While the cash flow between funds—considering the fluctuating price of oil—could garner these funds momentum in the short term, the corresponding risk might be enough to keep oil investors focused on more-traditional ETF strategies.
The Sector Momentum Tracker currently ranks several oil and energy funds, such as iShares Global Energy (NYSEARCA:IXC) and iShares Dow Energy (NYSEARCA:IYE), that have seen a resurgence in recent weeks. IXC recently fell from the No. 36 position on our Sector Momentum Table on October 14 to the No. 76 spot a week later on October 21. Since this move, IXC rebounded to the No. 47 position on December 2. IYE experienced a similar drop from October 14 to October 21, going from 33 to 68 in our rankings. Since late October, IYE has regained some of its momentum, holding the No. 48 spot on December 2. For investors willing to bet that oil will go higher, funds such as IYE and IXC present a sector exposure that could be more reasonable for long-term investors than could the long strategy offered by Macroshares.