Commodity Markets Are Coming Back - ETF/ETN Caution

by: Andrew Hecht


Contango + Bear Market + Leverage = Disaster.

UGAZ -- A Case Study.

Human nature says hang on -- resist this impulse.

Short-term instruments.

Unleveraged is the best bet for the medium term.

When it comes to commodities, ETF and ETN products changed the markets over recent years. The introduction of these instruments in 2004 marked the first time that market participants could invest or trade commodities directly without going to the physical or futures markets. These vehicles brought the volatile asset class directly to equity accounts. The SPDR Gold Shares ETF (NYSEARCA:GLD), introduced in 2004, has been the most successful ETF product in terms of tracking the behavior of gold on a short-medium and long-term basis. The reason for the success of GLD finds roots in the nature of gold itself. Gold is both a commodity and a financial asset.

In 2006, the introduction of The United States Oil ETF (NYSEARCA:USO) brought the ability to participate in one of the most actively traded and watched commodities -- crude oil -- to a larger addressable market of traders and investors. USO has not achieved the same degree of success as GLD. While USO attracted a great deal of interest, the ETF suffered from the effects of term-structure in the oil market. The GLD has done a great job tracking gold. It commenced trading at $44.40 per share in November 2004 when active month COMEX gold futures were at $429.50 per ounce. On Wednesday, March 16, GLD closed at $120.59 per share, with April gold at around the $1260 level.

USO commenced trading at $68.25 per share in April 2006 with the active month NYMEX crude oil contract at $66.36 per barrel. On March 16, USO closed at $10.18, with April NYMEX crude oil at $38.46 per barrel. The contrast in performance speaks for itself. Each of these products does a good job of tracking the performance of the underlying commodity on an intra-day basis; however, when it comes to long-term performance, GLD outshines USO.

After the introduction of these market vehicles, ETF and ETN shops cranked out many commodity-based products. These instruments have added liquidity to the futures markets themselves, as they generate volume from administrators hedging the products. They have likely added to market volatility, exacerbating highs and lows in markets as more participants have dipped their toes into the exciting world of commodity trading.

Some ETF and ETN products are unleveraged, like USO and GLD and others are leveraged, turbo-charging results for those who choose to include them in their portfolios. Everyone loves a winner, and when it is a leveraged winner, profits can be massive on a percentage basis in a very short time. However, a leveraged loser can often be a disaster. Many investors still make the mistake of using many of these instruments for medium- or long-term investment purposes even though many are not appropriate for that purpose. The GLD and SLV, the unleveraged silver ETF, are in a class by themselves given their utility for long-term investing. However, many other vehicles that track commodity prices, leveraged and unleveraged alike, are only useful to express very short-term market opinions.

Contango + Bear Market + Leverage = Disaster

Since 2011/2012, commodities have been in a brutal bear market. Copper, crude oil, and other important industrial raw materials continued to make new multi-year lows in January and February of 2016. However, we have seen signs over recent weeks that these commodities have made important bottoms. The bear market in commodities caused losses for many looking to buy price dips in search of a bottom. While we experienced a number of recovery rallies, many of these markets spent years making lower highs and lower lows. The recent upturn in commodity prices is likely to entice the investment community back to ETF and ETNs and their collective memory could be short, therefore, a word of caution is appropriate for those considering these products.

ETF and ETN products afford investors and traders the ability to participate in specific commodity markets in their brokerage accounts without going to the highly leveraged and volatile futures arena. However, those venturing into leveraged commodity ETF and ETN products do not avoid the turbulence of commodities as these products, in many cases, brutally underperformed the futures and physical prices even when leverage is taken into account. The bottom line is that the bear market combined with leverage caused some ugly results. A return to bull market conditions does not necessarily guarantee that many of these products will perform well over time. In fact, exactly the opposite may be true.

Contango is a market condition whereby deferred commodity prices trade at higher levels than nearby prices. This type of market structure is indicative of an oversupplied market condition. In other words, when supplies exceed demand, deferred prices are higher than nearby prices. The theory that underlies contango is that while ample inventories depress the nearby price, future production will reflect nearby prices and output will decrease. Additionally, demand rises in response to the low price, which depletes inventories, thus prices in the future trade at a premium to the nearby price.

The administrators of ETF and ETN products produce correlative products by using either the physical commodity or the derivative markets to underpin the instrument. As such, many ETF and ETNs use swaps, forwards, and/or futures as a hedge to create an instrument that reflects the price movement in the underlying asset. When the derivatives approach delivery or expiration dates, the risk exposure is rolled forward to another, further, date in the future. The administrator sells the hedge at one price and replaces it at a higher price. This means that the product eats the cost of the roll in a contango market, depressing the return of the instrument. Therefore, a bear market plus contango exacerbates losses. When it comes to leveraged ETF and ETN products, another layer of ugliness affects performance. Administrators of these products use option positions to turbo-charge returns. That adds another layer of cost to the products, theta or time-decay. All of these costs add up quickly and the result can be staggering for an investor or trader. The bottom line is, the bear market plus contango plus leverage has resulted in disaster for those on the long side of many ETF and ETN commodity vehicles since 2011/2012.

UGAZ -- A Case Study

The perfect example of a leveraged ETN that has caused so many so much pain over recent years is the Velocity Shares 3X Bullish Natural Gas ETN (NYSEARCA:UGAZ). UGAZ is a very popular ETF; it trades an average daily volume of almost 2 million shares these days. That is after UGAZ underwent a 1 for 25 reverse split on March 14 -- before last week, UGAZ traded an average daily volume of almost 50 million shares. This leveraged product that purports to magnify the change in the price of natural gas by three times the move in the NYMEX natural gas futures market has actually done a lot worse than triple the losses since 2012. The monthly chart of NYMEX natural gas futures shows that the price of this commodity in February 2012 was trading at the $2.50 per MMBtu level. Natural gas closed on Thursday, March 17 at around $1.94 -- therefore, the price of the energy commodity declined by 22.4% over the four years and one month period. Meanwhile, the price of the leveraged UGAZ natural gas ETN product was trading at a split-adjusted $7,070 per share in February 2012 -- it closed on March 17 at $ 26.45 per share -- a decline of 99.60%. Contango, theta, lower prices and leverage all added up to create a disaster for holders of this ETN product.

UGAZ has a complimentary product, DGAZ which is the Velocity Shares 3X Bearish Natural Gas ETN. One might think that this would have been the right position given the slaughter in the bullish ETN over the period. One would be very wrong in that assumption. An investment in DGAZ over the period would have yielded ugly results as well. DGAZ was trading at $53.74 in February 2012, on March 17 it closed at $19.80 - a decline of over 63% over the period.

These are two leveraged instruments; where there is leverage there is the potential for disaster. However, even the unleveraged natural gas ETF product, UNG, has posted ugly results over the period. UNG was at $22 in February 2012; on March 17 it closed at $6.83 -- a decline of 69%. The result of holding an unleveraged natural gas ETF over a period when the price of the commodity fell 22.4% was more than three times as bad as the nominal price action in the commodity.

The professionals that trade these instruments trade them from the short side as a rule, but retail traders keep coming back for more pain.

Human nature says hang on -- resist this impulse

A long-term investment in UGAZ, DGAZ, UNG or most every other ETF or ETN product has amounted to a lotto ticket with the odds heavily stacked in favor of the shorts. However, many investors bought these products as they moved lower. The products have become eggs in their portfolios that will never hatch, their owners sitting on them like mother hens with no idea that the shells are empty. Human nature is to hold an investment that has declined for better days, however, when it comes to ETF and ETN products, we must resist this impulse. I too am guilty of the mother hen attitude to some of these products. I am sure that portfolios are filled with these products showing 95%-plus losses over the life of the investment. At that point the only reasons to sell would be for tax loss purposes as they are worth pennies, or so that one does not have to continue to endure the folly of owning them in the first place. I too have learned this expensive lesson. Most of these products are only appropriate for day trading purposes.

Short-term instruments

The attraction of ETF and ETN products is that when the timing is perfect, they can double, triple or more in very short order. However, that is a rare exception and not the norm. Over time, these products decay in value faster than one can imagine. When it comes to the leveraged instruments, holding them over periods longer than one week is generally a huge mistake. These days, I rarely hold them for longer than a few hours.

Unleveraged is the best bet for the medium term

The unleveraged instruments have a slower rate of decay, however, discipline and time stops are of paramount importance for investing or trading purposes. The longest holding term on an unleveraged ETF or ETN should be a few weeks to a month. Of course, each of these instruments has its own idiosyncratic characteristics. Those that represent a series of deferred futures contracts mitigate risk to a degree. Some of the unleveraged precious metals ETFs are an exception. However, those that depend on only nearby futures contracts are only appropriate for very short-term investment.

The bottom line is that one must develop a trading plan when using unleveraged or leveraged ETF and ETN products. We must define time horizons. We must understand the products we trade or invest in and the instruments they replicate. Simply being bullish or bearish on an underlying market is not sufficient reason to enter a position in the unknown. Finally, we must have clear profit targets and stops for these instruments from the inception of each trade once we have all the information. There is a reason that professional traders are short these instruments the vast majority of the time. They are decaying assets.

Be careful out there; commodity volatility is treacherous these days and the raw material markets could be coming back into bull mode. The lure of commodity-based ETFs and ETNs is likely to increase over coming weeks and months. The bear market in commodities has taught us many lessons about risk in this asset class. Those who flock to these equity-based products do so to avoid the risk of the leveraged futures markets. The perception of less risk in ETFs and ETNs is a mirage. In many cases, the risks are even greater than in the futures arena. Remember, while futures are derivatives ETFs and ETNs that correlate to futures, prices are derivatives of those derivatives. They are one step further removed. ETF and ETN products can be great additions to your trading or investment activities, but realize their shortcomings, do your homework and only use them if you have a solid short-term plan.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.