After a chaotic 2008, most financial markets regained some degree of normalcy in 2009, as unprecedented volatilities subsided and a gradual calming of anxieties led to the return of rational trading. But for exchange-traded commodity products 2009 was a rather tumultuous period, as expectations for increasingly stringent regulations swirled and correlations began to break down.
The ETF industry has grown by leaps and bounds in recent years, but the learning curve is still a steep one, and investors are continuing to educate themselves on the nuances of some of the more complex funds. One of the fastest growing areas of the industry has also been home to some of the biggest misconceptions: commodity ETPs have taken in billions of dollars, but have confused investors who failed to fully understand the investment objectives of these funds.
One of the biggest misconceptions has related to the performance and strategy of exchange-traded commodities. The properties of many resources make physical storage impractical, meaning that a futures-based strategy the best way to gain exposure to such commodities. The overall simplicity of the exchange-traded structure has led many investors who would not normally jump into the futures markets to indirectly invest in these derivative instruments through wildly-popular products like the United States Natural Gas Fund (UNG) and United States Oil Fund (USO).
But after disappointing performances from these funds in 2009, the pendulum has swung in the opposite direction, and many investors believe that futures-based ETCs should be avoided at all costs. As usual, the truth lies somewhere in the middle. Funds like UNG and USO do an excellent job of accomplishing their stated objective. But in many cases there is a disconnect between the stated objectives and investor expectations. Futures-based exchange-traded products can be tremendously powerful tools if used correctly, but can have unintended consequences in the hands of those who don’t fully understand their methodologies and processes. Futures-based ETCs should be viewed by investors not as commodities, but as futures contracts.
Much has been made of UNG’s 2009 performance, as billions of dollars flowed into a fund that posted one of the worst returns for the year. UNG has been criticized because its performance diverged sharply from a hypothetical return on spot natural gas prices, raising concerns that the fund doesn’t come close to tracking the price of its underlying commodity.
As the chart above shows, the gap between returns on UNG and a hypothetical natural portfolio has not always been as significant as it was during the second half of 2009. Between the natural gas peak in early July 2008 and the bottom in September 2009, UNG’s performance trailed spot natural gas by only about 4%, exhibiting a pretty strong correlation.
UNG has run into trouble when natural gas prices have surged, as they did between September 2007 and July of the following year and again in the final four months of 2009. When the futures markets are sloping upwards, as they were during these periods, the “roll yield” incurred by a futures-based strategy is often at its greatest, exposing UNG to potential return erosion.
During these periods, natural gas prices have essentially followed the futures curve, which translates into flat performance for a portfolio composed of futures contracts.
While UNG has been in the spotlight in 2009, the United States Oil Fund (USO) has suffered from similar factors over the last year, as contango in futures markets caused a wide disconnect between the rise in spot crude prices and the performance of USO.
Between its inception in April of 2006 and the end of 2008, USO showed a strong correlation with spot oil prices, roughly replicating market movements.
But similar to UNG, 2009 has been a completely different story for USO. Crude prices crept gradually higher, but moved mostly along the futures curve, resulting in smaller returns for USO relative to spot prices.
While futures markets for energy commodities often receive the most attention and are subject to the most thorough analysis, contango can have an impact on any commodity, and has historically been a component of total returns to precious metals exchange-traded products.
There are a handful of gold exchange-traded products out there that come in two main forms. Physically-backed gold ETFs, including the SPDR Gold Trust (GLD), iShares COMEX Gold Trust (IAU), and ETFS Physical Swiss Gold Shares (SGOL) buy and store gold bullion in secure vaults. Futures-based gold products, including the PowerShares DB Gold Fund (DGL) and UBS E-TRACS CMCI Gold Total Return (UBG), invest in gold futures to track the price of the precious metal.
Historically, these two strategies have shown a strong positive correlation, but some minor disconnects have developed. Since its launch in January 2007, DGL has delivered an average annual return of 19.6%, while GLD has gained 22.2% per year over that period. The gap between these funds is dwarfed by the differences arising in energy commodities, but is nevertheless significant.
Similar to gold, returns between physically backed silver funds and those that employ a futures-based strategy have been minimal over the last several years. Since its inception, the PowerShares DB Silver Fund (DBS) an average annual return of about 10.1%, while the iShares Silver Trust (SLV) is up 12.3% per annum over that period.
As many investors have learned the hard way, employing a futures-based investment strategy is a complex process as the returns ultimately delivered by such a strategy can be impacted by a number of factors.
A number of studies have shown that the addition of commodities to traditional stock-and-bond-only portfolios can have a material impact on both bottom line return and overall volatility. Historically, exposure to many commodities has been most readily available through futures contracts. Now, futures-based ETFs present a more widely-available alternative. While these ETCs aren’t exactly a wolf in sheep’s clothing, the complexities remain, presenting the potential for misuse.
Disclosure: No positions at time of writing.