Sunday, November 15, 2009 0 comments ++[ CLICK TO COMMENT ]++

Newbie lesson: investing directly in commodities can be painful

Wall Street is very good at creating new securities and enriching themselves in the process. That's how the financial professionals earn more than workers in other industries. But it serves a social good in innovating finance. So, every boom is accompanied by some financial product created to satisfy investor demand. Of course, the most memorable, recent, example are mortgage-backed securities of various types (such as CDOs) to satisfy the demand for safe high-yield products. The dot-com bubble popularized IPOs and new share issuance.

The recent boom in commodities resulted in the creation of commodity ETFs. The commodity ETFs, like most other Wall Street innovations of late, has sucked a big chunk of wealth from investors. Overall, it is good to see commodity ETFs since they let small investors have the chance to invest directly in commodities. Traders are also big fans of these products and it doens't really hurt them that much (since their holding period is short.)

However, long-term investors should be really careful with commodity ETFs. It is very difficult to invest in a product that tracks the underlying commodity very well. I want to demonstrate the pitfalls of commodity ETF investing by looking at natural gas.

The following charts plot natural gas and an ETF that tracks natural gas. I should note that the ETF contains a mixture of contracts and doesn't represent the spot price. Nevertheless, it is very close and many treat it as the equivalent to natural gas.

I want to highlight two things.

First of all, let's look at the major crash from July 2008. As you can see, the spot price declined around 77% while the ETF fell 85%. Although not a big difference relative to the total decline, it is still a big diference in raw terms. You are looking at an 8% greater loss. If you consider the fact that stocks return 10% per year in the very long run, that's almost an year's worth of loss. Furthermore, if the ETF keeps losing 8% per year more than the underlying commodity (although it is possible it may gain 8% more in some years), long-term investors can lose a fortune within 5 years.

The other point—this is really the point of this post—is to illustrate what has happened in the last few months. Natural gas has been selling off in the last month but it is still more than 50% above its multi-year low set slightly below $3. In contrast, the ETF really didn't rally much and is essentially near the multi-year low set in August. The ETF holdings do not exactly represent the spot but, nevertheless, one might have imagined that it would be close. But it isn't.

There isn't anything wrong with the ETF. The ETF may be selling off because the distant contracts are selling off (ETF holds longer-dated futures) i.e. structure of the futures curve is changing. Professionals and hedge funds may also be picking off the sitting ducks—the ducks being the ETF investors—since there are problems with ETFs holding very large commodity positions trying to roll them over. It is also possible that there is some arbitrage problems—large ETFs track their underlying index closely but commodity ETFs had problems due to regulatory concerns—so it's not clear what is happening. I don't follow UNG so haven't really looked into it. The point I'm trying to make is that it is very hard for small investors to invest in underlying commodities. If you are buying a commodity ETF, make sure you know what that represents. It will almost never track the spot price.

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