Some commodity-tracking ETFs actually hold commodities under lock and key. Others, like United States Oil Fund (AMEX:USO - News), hold futures contracts -- storing barrels of gooey oil would be too messy.
The result is that USO investors have been nearly as big a group of losers as SUV drivers. While light, sweet crude oil ran up just shy of $70 a barrel, a 14% rise this year, USO is up a measly 1% this year. PowerShares DB Oil Fund's (AMEX:DBO - News) returns have come closer, with a 12% gain.
The IPath S&P GSCI Crude Oil Total Return Index (NYSE:OIL - News) exchange traded note has dropped 6.4%.
Contango Compounded
USO shows the compounding results of contango. You get contango when the next month's futures contract is more expensive than the current month's.
So every time the contract rolls from one month to the next, the fund has to buy the next month's at a higher price. Thus, the fund loses money.
John Hyland, director of portfolio research at Victoria Asset Management, which runs USO, could not comment on the matter because his firm has filed two other oil ETFs that track U.S. heating oil and gasoline with the SEC.
But in an April SEC filing, the company said: "It is not the intent of USO to be operated in a fashion such that its net asset value will equal, in dollar terms, the dollar price of the spot price of WTI Oil (West Texas Intermediate light, sweet crude oil) or any particular futures contract based on WTI Oil."
Furthermore, Victoria said USO aims to track changes in the price of the futures contract on WTI oil. Therefore, the fund does what it was designed to do.
Unlike the underlying commodity, futures contracts are highly sensitive to interest rates. Because buyers put up only a small amount of cash to buy the futures, they can invest the rest of the money in Treasuries to earn interest.
There's also liquidity issues and tracking problems, says Jeff Buetow, chief investment officer for XTF Advisors.
"Whenever you're using an underlying investment strategy that's tied to complicated derivative structures, you're going to get unexpected return performance that's materially different from the underlying commodity that you're trying to track," he said.
Backwardation
But investors can benefit from the opposite of contango: backwardation. That's when the next month's contract costs less than the current month's. So investors get to sell high and buy low.
This happens when supplies are tight and buyers are willing to pay more for spot prices. They're more concerned about immediate access than the cost of storage.
To complicate matters, there's Claymore MACROshares Oil Up Tradeable Shares (AMEX:UCR - News), which is up 19% this year, and Claymore MACROshares Oil Down (AMEX:DCR - News), which is down 21%. But these aren't ETFs. The explanation for their performance is a story for the near future.
