Commodity ETFs are dangerous. They don’t make the cut in any of our algorithms.
This week, the Financial Times outlined ($) one of the many issues with products like USO, UNG, and CORN.
Investors have learnt the hard way that many commodity ETFs do not work if held over long periods. The worldwide commodities glut not only depressed prices but pushed down many spot commodity prices compared to those for future delivery. This pattern, known as contango, ate up investors’ money as ETFs that owned futures effectively sold low and bought high each time they replaced expiring contracts with more expensive ones.
Investors who buy these ETFs hoping to participate in rising prices are constantly disappointed as they watch their holding lag (sometimes terribly) the underlying commodity price. That’s why this chart of increasing inflows is worrying.
The bottom line is – commodity ETFs track short-term moves well, but become increasingly ineffective the longer the ETF is held. Day traders and 1 – 5 day swing traders are in the best position to profit from these investment vehicles. That is echoed by the FT article:
With average volumes of about 45m a day, the [USO] fund’s 287m shares outstanding turn over every six days.
“These ETFs have never been intended to be, ‘buy and hold’ investments and the companies offering them have been very clear on this provided you actually read the information given.” – Jesse Cates of Midland, Texas
So what if you want long-term exposure to a commodity? If you think Crude Oil is going back to $100 a year from now, how do you get in without buying an ETF? Via futures. If you want exposure to the annual price move of Crude Oil, buy the December futures contact one year out. This avoids the costs (in contango) of rolling the contract each month. Had you done that at the end of 2015, you would have outperformed the Crude Oil ETF USO by a whopping 10%.
That being said, we wouldn’t recommend anybody use a buy-and-hold commodity strategy. When we were first developing algorithms, it quickly became clear that even holding commodities as part of a tactical portfolio does not enhance risk-adjusted returns. Skip them altogether. Check out our work.