Friday, July 31, 2009

Crude ETF Trading Is A Joke!

I will have a much more detailed posting about Leveraged ETF'S in general coming soon.

Its just more money in the pockets of the bankers and structured finance guys (Me Being One Of Them Once) working on Wall Street.

I posted about how Wall Street keeps creating complex products so that bankers and traders can continue to buy brand new Ferrari's every few years.

But just take a look at these two charts, and you will realize that the joke is on you.


Crude Oil Vs. USO - US Oil Fund.

Both have badly missed its benchmark commodity.

Crude has rallied some 55% this year. The corresponding instruments badly missing the run up in Crude.

Just a note before I proceed.

For the Retail Crude Oil Speculator (You The Sucker) who is incapable of trading crude oil futures, there are tradeable ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes) which employ futures contracts in pursuit of the general objective of “tracking the price of crude oil”. A typical crude oil ETF/ETN will hold long positions in WTI (West Texas Intermediate) crude oil futures contracts. As with most futures traders, these funds employ leverage, putting up a small portion of the capital to buy the contracts. The rest of the fund’s assets are invested in money market instruments which generate a modest amount of interest income for the fund.

What typically happens in theory is the following.

Crude Oil ETF/ETN exists so that individuals can speculate on the equity side what direction crude is going in. What the normal investor doesn't understand is that this rather simple strategy is hindered and compromised by the existence of the Forward Crude Oil Curve. Because of this forward Curve, any ETF/ETN referencing crude oil cannot simply rely on ownership of the existing front month (closest to expiration) futures contract. To remain invested at all times,the Portfolio Manager must periodically sell its existing futures holdings and roll its exposure to a futures contract expiring in a more distant month. So every time the front month crude contract rolls to the next month, there is massive performance return that is lost.

With crude oil ETF/ETN the real world result of utilizing crude oil futures to derive the Net Asset Value of the corresponding fund has some distinct variables.

-Direct changes/fluctuations in the spot price of crude oil, a price that retail investors cant trade.

- The Interest earned on any cash in the ETF itself that is not currently invested.

Most Importantly.

- The "Roll Yield" is involved.

Which essentially is a function of the spread between the price of the current contract being sold and the price of the future contract being bought.

In contango markets [Upward Sloping Forward Curve], the roll yield will be negative because the fund must pay up to enter the more future contract, and the opposite is true in backwardated [Downward Sloping] markets.

Furthermore, the precise timing of the forward roll can have a material impact due to the propensity of the expiring contract to experience high volatility in the days immediately prior to expiration.

For example:

Assume that the 2009 spot return on crude oil is +50%. But, assume that persistent contango in the market results in a cumulative roll yield of -35 %. In these circumstances, the combined return of a crude oil based ETF might be in the ballpark of +15%, a far cry from the +50% return generated in the crude oil spot market. This is not taking into account fees, etc.

The variability of roll yields coupled with the shifting slope of the forward curve should dispel any notion that the return on crude oil ETFs/ETn's will track the spot market of crude oil in a predictable manner. This never happens.

The managers of the crude oil ETF/ETN are fully aware of this issue and they make no claims regarding their ability to replicate spot crude returns. They merely claim to "attempt" to track a return benchmark that is comprised of crude oil futures contracts. Generally these trading instruments are severely deficient in terms of tracking the underlying commodity.

That is exactly what is happening to the two funds mentioned above.

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