Understanding Commodity ETFs
Introduction
One reason for the explosive growth of the ETF industry is that ETFs have dramatically expanded the way that investors can trade commodities.
If you are new to ETFs and don't understand the difference between and ETF and an ETN, you can read what is an ETN?
One reason for the growth of the commodity ETF industry is that ETFs make it easy to trade commodities using leverage. ETFs also make it easy to trade commodities because there are a lot of inverse commodity ETFs - commodity ETFs that will go up in value if the price of a commodity declines.
If you are new to ETFs, you can read what is a leveraged ETF? and what is an inverse ETF?
What is a commodity future?
Most commodity ETFs are designed to track the price of a commodity such as oil or natural gas. But it isn't practical for an ETF to actually own (and store in inventory) oil and natural gas. So commodity related ETFs usually own "futures" on the commodities they are trying to track (corn, oil, gas, wheat, etc...). A future is a type of option - the right to take delivery of a set amount of the commodity at a specified future date.
Commodity futures are traded on stock exchanges - the largest commodity exchange is the NYMEX exchange owned by the CME Group. Like stock options, commodity futures are traded with different "delivery dates" - the date on which the owner of the future has to take delivery of the commodity. The most heavily traded commodity futures are those with delivery dates in the next 30 days. These are commonly referred to as "front month" futures. But you can buy and sell futures with delivery dates going out as far as a year. As example, you can look at the different delivery date futures that are currently trading on WTI crude oil futures.
Note that commodity futures are primarily traded by investors and traders who have no intention of actually owning the future on the delivery date of the future. These investors and traders generally sell any futures they own right before the delivery date, and then, if they want to continue to have exposure to the commodity, they immediately buy new futures with longer delivery dates. Investors and traders have to hope that by buying and selling futures in this manner, by constantly "rolling" their futures, their investment will "mirror" the price of the underlying commodity.
Commodity indexes
Most commodity ETFs are tracking an index.
Commodity indexes are different than stock and bond indexes because most commodity indexes are tracking the theoretical performance of an investor who is buying and selling commodity futures on a set pattern. There are two types of commodity indexes:
- An excess return or "ER" index
- A total return index
The ER index is the returns an investor would get from buying and selling the commodity futures.
A total return index for a commodity includes the returns from buying and selling the commodity futures (i.e. the ER index) plus a theoretical amount of interest that an investor would earn from the theoretical cash that the investor has to have on hand to buy the commodity futures. Usually, the theoretical amount of interest is based on U.S. treasury bills, but it can vary by index.
Commodity futures are a type of option, and like all options, they are highly leveraged. When you buy a commodity future, you don't have to pay the full value of the contract up front. Instead, you have to maintain in your brokerage account sufficient capital, or "margin" to cover any potential losses. This "margin" is a percentage of the full contract value of the futures, usually between 3% and 9%. This margin cash is also sometimes referred to as "collateral" cash. So investors buying and selling commodity futures always have to have a large cash balance sitting in their account, to cover the margin. This cash earns interest, but usually at fairly low interest rates, because it is usually invested in short-term securities like U.S. treasury bills and/or money market funds. The "ER" index does NOT factor in this interest earned on the cash. The total return index does include this interest.
Theoretically, a commodity ETF should seek to track the total return index, not the ER index, because the total return index reflects what the ETF is actually doing on a day to day basis, including managing the large amounts of margin cash on hand. Nevertheless, some ETFs state that they are trying to track the ER index.
Commodity ETNs, on the other hand, can seek to track either an ER index or a total return index, so you have to read the ETN's website or prospectus. Remember, an ETN doesn't make investments, but rather is just a promise from the bank. So the bank behind the ETN can choose to track whatever index it wants to.
You can occasionally find a "spot" commodity index, which is designed to track the changes in the "spot" price of a commodity. The spot price of a commodity is the price you would pay today to buy that commodity, without entering into a futures contract. The ETF industry hasn't figured out a way to buy and sell commodities in a way that would track a spot index, so spot indexes are not considered to be "investable", and thus not very common.
Risks associated with futures based ETFs
There are special risks associated with any ETF that is futures based.
Risk #1 - Tracking error
A commodities related ETF like USO, the United States Oil Fund ETF, is designed to track the movements of WTI crude oil prices. But because it wouldn't be practical for the fund to actually own and store in a warehouse oil, the fund instead buys WTI crude oil futures - the right to take delivery of WTI crude oil at a future date. Because the fund doesn't want to actually take delivery of the WTI crude oil when the future expires, the fund has to sell the futures it owns at some point before the actual delivery date arrives. So the fund is constantly buying and selling futures. When you buy shares in USO, you are in essence buying the WTI crude oil futures that the fund currently owns.
But buying and selling WTI crude oil futures doesn't really accurately track the "spot" price of crude oil. So when you are looking at buying a futures based ETF like USO, you have to constantly remind yourself that you are actually buying futures that may or may not accurately track the true price of oil.
Risk #2 - Poor Performance Due to Contango In The Futures Market
A commodity ETF is constantly buying and selling futures, especially a commodity ETF that buys futures with the nearest delivery dates, or "front month futures". These futures typically have delivery dates that are 30 days out, so a commodity ETF that owns front month futures has to "roll" the futures it owns every month -- it has to sell the futures it owns, and buy new ones with delivery dates for next month. During the course of rolling futures, most commodity ETFs inevitably lose money, in what is referred to as a "roll cost".
The roll cost related to futures is generally higher when the futures market is in "contango". Contango is a funny term that gets used, but let's first explain it in simple terms. Contango refers to a futures market where futures with a longer delivery date (farther out in the future), are more expensive than futures with shorter delivery dates. The typical state of a futures market is to be in a state of "contango".
The opposite market condition to contango is known as backwardation. A market is 'in backwardation' when the futures with longer delivery dates are cheaper than futures with shorter delivery dates. Backwardation doesn't happen very often in a futures market.
Why does contango create poor performance for an ETF like USO or UNG? If USO owns 1,000 futures contracts that have a delivery date 30 days from now, USO will need to sell those contracts, because they don't want to take delivery of the oil. So they sell those 1,000 contracts. But the fund has to stay fully invested in oil futures, so the fund then has to buy 1,000 futures contracts that have a delivery date 60 days from now. Because of contango, they will lose money on this trade because the futures with a delivery date 60 days from now will cost them more than the futures they just sold with a delivery date 30 days from now.
Can an ETF prevent poor performance due to contango? Maybe. Some ETFs are trying to minimize the effects of contango by buying and selling different types of futures with different future delivery dates. UNG only buys short-term futures or so-called front month futures - those futures with with nearest delivery dates. UNL, on the other hand, buys futures with delivery dates spread throughout the upcoming year. The difference in performance between UNG and UNL can be significant.
UNG was one of the first natural gas ETFs, so it is popular. But you should not own UNG for any extended periods of time because over time it does not perform well. So it is more of a short-term trading vehicle rather than a long-term investment. The ETF industry is still working at figuring out ways to enhance futures-based ETFs to minimize the above risks, so alternative approaches like UNL are being developed.
Complex tax issues
Note that there are a high number of commodity ETNs compared to commodity ETFs. This is primarily due to U.S. regulatory and tax treatment of commodity traders. Normally, an ETF is a registered investment fund under the Investment Company Act of 1940, subject to regulation by the U.S. Securities and Exchange Commission. However, current federal income tax laws limit the ability of investment companies registered under the Investment Company Act of 1940 to invest directly in commodity futures contracts.
To avoid this limitation, many commodity ETFs are setup as a commodity pool that is not subject to regulation under the Investment Company Act of 1940. Commodity pools are setup under the Commodity Exchange Act, and regulated by the Commodity Futures Trading Commission or the “CFTC.” But this setup creates some tax reporting issues, as explained in the Complex Tax Issues section below.
The extra complexity associated with commodity ETFs probably explains why commodity related ETNs are so popular. Remember, a ETN is just a promise from a bank that is linked to the performance of an index, so a commodity ETN bypasses a lot of the complexities associated with a commodity ETF.
As explained above, many commodity ETFs are setup as a commodity pool under the Commodity Exchange Act, and regulated by the Commodity Futures Trading Commission or the “CFTC.” But this setup isn't perfect either. To avoid taxation at a fund level, many commodity pools are structured as "limited partnerships" , which are considered pass-through investments, so any gains made by the commodity pool are "marked to market" at the end of each year and passed on to its investors, potentially creating a taxable event. This means an investor's cost basis adjusts at year-end, and the investor can be subject to paying taxes on gains whether or not the investor sold shares. For tax reporting, limited partnership commodity pool ETFs are required at year end to generate a Schedule K-1 form for all investors. This can create uncertainty and annoyance for the average investor not familiar with K-1s when they receive these forms in the mail.
To avoid investors having to deal with Schedule K-1s, a commodity pool ETF can choose to be organized as a corporation, but then must organize a foreign subsidiary, usually in the Cayman Islands. The foreign subsidiary performs the actual commodity futures trading, thus avoiding U.S. tax limits on futures trading. This creates a complex setup, with complex rules about how the ETF and its foreign subsidiary can operate and interact with each other. But this setup allows an ETF to be a "K-1 free" ETF, which is a big deal to a lot of investors.