Wednesday, July 28, 2010

"Amber Waves of Pain" Pitfalls in Commodity ETF's (DBA; MOO; RJA)

Since I've been touting the soft commodities this month I thought this cautionary tale from BusinessWeek would be in order:

Lured by the idea of profiting from raw materials, investors put $277 billion into commodity ETFs and related securities by the end of 2009. Then they noticed a problem: When commodities go up, the commodity ETFs often don't 
Like so many investors in the spring of 2009, Gordon Wolf needed to dig out of a hole. A 68-year-old psychologist in Napa, Calif., Wolf was a buy-and-hold sort of guy, yet the nest egg he had entrusted to his broker at Merrill Lynch (MER) was suddenly down by more than 50 percent. The broker had invested much of it in a range of exchange-traded funds, or ETFs, a relatively new financial innovation that was replacing mutual funds in the hearts and portfolios of many investors.

An ETF, which can be bought or sold like a stock, attempts to track the price of a particular basket of assets—tech stocks, for instance, or high-yield bonds, or commodities ranging from wheat to gold to oil to natural gas. The commodity ETFs were supposed to offer a hedge against equity losses, but in the crash of 2008 everything fell in tandem. Now it was early 2009, and Wolf was watching oil fall to $34 a barrel. That had to be an opportunity, he figured, so he called his Merrill broker and asked about the U.S. Oil Fund (USO), an ETF designed to track the price of light, sweet crude. "This seems to be something good," Wolf told the broker, and had him buy about $10,000 of USO.

What happened next didn't make sense. Wolf watched oil go up as predicted, yet USO kept going down. In February 2009, for example, crude rose 7.4 percent while USO fell by 7.4 percent. What was going on? Wolf logged on to Seeking Alpha, a financial blog, and searched for USO. He found plenty of angry discussion about the fund—lots of people were losing lots of money, because thousands of American investors had seen the same sort of opportunity Wolf had. By the end of 2009, they had a record $277 billion invested in commodity ETFs and other securities linked to raw materials—a 50-fold jump from $5.5 billion a decade earlier, according to Barclays Capital. During that time, Wall Street had transformed the reputation of commodities from a hyper-volatile investment that can steal your shirt to a booster for battered portfolios, something that rose when stocks fell and hedged against inflation. People who would never think of buying a tanker of crude or a silo of wheat could now put both commodities in their 401(k)s. Suddenly everybody was a speculator.

And some were losing big. The commodity ETFs weren't living up to their hype, and the reason had to do with a word Wolf had never heard before. As he browsed the blogs, he says, "I'm seeing people talking about something called contango. Nobody would define it." Wolf called his broker and asked about contango. "I don't know what it is," he replied. He called his other broker, at Charles Schwab (SCHW). "He didn't know either," Wolf says. "He said he'd ask around." Weeks later, after Wolf educated himself, he fired his Merrill broker and pulled his money out. (Merrill and Schwab declined to comment.) By then he had lost $2,500 on USO. "If it wasn't a rigged game," he says, "I could figure it out. But it is a rigged game."

The Contango Trap

Contango is a word traders use to describe a specific market condition, when contracts for future delivery of a commodity are more expensive than near-term contracts for the same stuff. It is common in commodity markets, though as Wolf and other investors learned, it can spell doom for commodity ETFs. When the futures contracts that commodity funds own are about to expire, fund managers have to sell them and buy new ones; otherwise they would have to take delivery of billions of dollars' worth of raw materials. When they buy the more expensive contracts—more expensive thanks to contango—they lose money for their investors. Contango eats a fund's seed corn, chewing away its value....MUCH MORE (it was the cover story)

A quick note:
The writers get it. Not just the problem of the roll but how much Goldman makes by structuring trades based on the GSCI. They also mention how CalPERS got taken over the last few years, a point I howled into the wind all through 2008.