another WSJ piece on : idiot "long only" commodities people / ETFs / lousy returns / carrying charges ("contango")
DECEMBER 17, 2010
Getting Tripped Up by the Contango
A futures-market quirk can hurt commodities returns if investors aren't aware of it
By CAROLYN CUI
ETFs have made it a lot easier for small investors to play the commodities market. But there are potential pitfalls you need to know about before you jump in.
For a long time, small-time investors had only a couple of options for getting into commodities: trading futures contracts, which took deep pockets and lots of know-how; or buying mutual funds, which meant relying on a fund manager to pick investments, sometimes including commodity stocks, which could perform very differently from the commodities themselves.
Exchange-traded products promise investors more simplicity and control by letting them buy futures or physical commodities like gold as easily as buying stocks. For lots of people, it's a compelling pitch, particularly when commodity prices are booming.
But beware: While getting into the game may be easier, figuring out how is as tricky as ever. Even though commodities prices have been rising, a technical quirk has been sapping returns and many ETFs are only starting to address the problem.
Choose Carefully
"There are a lot of reasons to want exposure to commodities," says Michael Johnson, a senior analyst with ETF Database, an online provider of ETF research. "It's just a matter of coming up with the right vehicle."
The trickiness starts with a situation called contango. Before futures contracts expire, funds must trade out of them and into new ones. But new contracts usually cost more than the old ones, because of financing and storage costs for commodities. So investors lose a small portion of returns.
But over the past two years, this contango effect has been much stronger and more persistent than usual. Why? The poor economy is depressing near-term demand for many goods, from oil to base metals. At the same time, many pros think the sector will rebound, thanks to strong demand for raw materials in emerging markets. That's driving up the price of contracts for future delivery and investors are losing much more of their returns.
Dancing With Contango
To be sure, most commodities are up in price enormously over the past two years. But investors haven't fully enjoyed the gains because they are losing out as the contracts roll over month to month. For example, U.S. Oil Fund is an ETF designed to track the move of spot prices of light, sweet crude oil as reflected in futures traded on the New York Mercantile Exchange. Since its inception in April 2006, the $1.9 billion fund has tumbled 44.4% as spot prices have risen 27.8%, largely due to contango's impact in the futures market.
Standard & Poor's estimates that contango has eroded 52.2 percentage points of investor returns in S&P's GSCI, a commodity index, since the beginning of 2009. Without negative rolling costs, investors would have earned 65% instead of the actual 12.8%. "It has been a symptom of the financial crisis over the last couple of years," says Martin Kremenstein, chief investment officer of Deutsche Bank AG's DB Commodity Services.
Is there any way around contango? One is to buy and hold physical products,*** which is what precious-metals funds typically do. Gold, in fact, is the most popular type of commodity ETF; SPDR Gold Shares has $57.2 billion in assets by itself, 58% of the $97.9 billion in commodity ETFs as of November, according to the National Stock Exchange, an ETF data provider. BlackRock Inc. and ETF Securities Ltd. also run ETFs backed with physical precious metals.
[*** then you are losing interest, and also spending your own money on storage costs and insurance]
Both J.P. Morgan Chase & Co. and BlackRock have filed with the Securities and Exchange Commission for a copper ETF, which would hold supplies of the metal. Many analysts are skeptical. Some argue that storage costs might be too high, since copper is bulky and takes more space to store; it's also cheaper than bullion, so the storage costs are bigger in proportion to copper's value. Other analysts say that a copper ETF might distort the copper market. J.P. Morgan and BlackRock both declined to comment, citing the regulatory restriction when funds are waiting for approval.
Funds that deal in futures contracts don't have the option of buying actual goods. They can, however, be choosier about what contracts they buy.
Investing in the front month's contract the one closest to expiration is the simplest way to invest in commodities and track the spot prices, since these contracts are the most liquid. But these contracts also tend to see the steepest contango. PowerShares DB Oil Fund takes a different approach, choosing the cheapest forward contract to roll into. The fund, run by Deutsche Bank, is down 1.3% this year, while oil is up 10.5%.
[uh ... sign me up ? because they only under-performed by over 1100 basis points ???]
Smaller players are trying innovative approaches, as well such as K. Geert Rouwenhorst, a finance professor at Yale University. His company, SummerHaven Investment Management, runs the trading for the $70 million U.S. Commodity Index Fund, an ETF that invests in commodities that have the lowest inventories. Since its August inception, the fund has gained 22.6%, beating big rivals such as the $2.7 billion iPath Dow Jones-UBS Commodity Index Total Return ETN, which rose 15% during the period. Now SummerHaven is planning sector funds on metals and agriculture, as well as a single-commodity fund on copper.
Mr. Rouwenhorst has an interesting pedigree in the field: In 2004, he co-authored a paper that proved the benefits of adding commodities to a portfolio of stocks and bonds, and inspired a wave of commodity funds.
[this person may go down in history as having caused more money to be lost by (previously) conservative pension funds than anyone since (the "great") McGeorge Bundy (who convinced many to buy vastly over-priced "nifty fifty" - type stocks in the early 1970s)]
Another new entrant: Sal Gilbertie. Last year, he left Newedge Group as head of the over-the-counter trading desk for energy derivatives to launch a commodity ETF. The Teucrium Corn Fund is never invested in the front month's contract a way to mitigate contango but split among three contracts that include at least one in December, which is especially liquid. Most of the corn around the world is harvested by December, so farmers tend to use the contract expiring that month to hedge their price risk.
The $40 million corn fund is up 46% since its June launch, while prices of front-month corn contracts have gained 73.7%. Teucrium has five more ETFs on crude oil, natural gas, sugar, soybeans and wheat in the pipeline, according to filings.
Ms. Cui is a staff reporter in The Wall Street Journal's New York bureau. She can be reached at carolyn.cui@wsj.com.
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