(too) Large-by-(too) large in terms of the sandbox in which they play and thereby hangs a tale.
From FT Alphaville
The United States Oil Fund mystery, revived
What has happened before will happen again (as someone on a sci-fi TV show once said).
In 2008/9 the USO ETF (United States Oil Fund) roiled the oil market when its assets under management mushroomed in size in response to apparently epic inflows from passive long investors.
The issue at hand was the fund’s obligation to invest in front month WTI contracts which — under its investment mandate — it was charged with rolling over in a predictable manner every month.
....MUCH MORERolling contracts in such a way exposes fund investors to two possible scenarios: 1) disproportional outperformance because the market is discounting the future versus the front-month (a structure known as a backwardation), meaning it becomes cheaper to maintain the same position over time which leads to gains on a per ETF unit basis 2) disproportional underperformance because the market is pricing the future in at a premium relative to the front-month (known as a contango), meaning it becomes more costly to maintain positions over time which leads to losses on a per ETF unit basis.
As the fund’s open derivative positions began to dominate front-month open interest in what was then a contango — and thus loss-inducing — market, the rolls became game-able. The wider market soon realised that if it too piled into the contracts ahead of the fund it could profit at its expense by ensuring it would cost the USO ever more to rollover its positions.
In turn this front-running exacerbated the contango, which increased the profitability of buying physical oil and putting it into storage while selling it simultaneously for a guaranteed profit at some point in the future.
Much debate was had on the topic of whether index funds — due to their passive nature — had the capacity to distort the underlying physical market as a result. To calm concerns, regulators soon introduced stricter position limits on derivative contracts to limit the possible impact of outsized positions on physical markets.
From the get-go the fund’s transparency was a key part of the problem. It was just too easily anticipated in the market.
And yet, what people really wanted to know was how come — given the overall bearish sentiment at the time — retail investors were so keen to pile into the oil market so intensively at this point? How come they had so much more risk appetite for bottom-hunting than managed money investors or other institutions?
Over the course of the next few months and years, FT Alphaville discovered that attributing that sudden growth of the fund solely to bullish retail investors was probably too simplistic....
Also at FT Alphaville:
Unprecedented oil commentary
The FT should probably keep this writer, she seems to have potential.
