Why You Should Generally Avoid Commodity ETFs Despite Inflation, Commodity Prices Rising

Happy Monday, Rudes!

I thought I’d start the week out with a warning and an explanation rather than just a news rundown.  It may save your bacon if you’re looking at how to take advantage of the imminent inflation hike.

Inflation, Up.  Commodities, Up.  Let’s do Commodity ETFs!

It makes total sense.  You think, “Inflation is happening.  Lumber, copper, and coffee prices are going through the roof.  But I don’t know if I’ve missed these rallies, or which ones will go up next, so I probably should buy a commodity ETF.”

The thinking is sound.  But for reasons I’ll demonstrate in today’s Rude, most commodity ETFs should be avoided like the plague.

What are ETFs?

Very briefly, to make sure we’re on the same page, I’ll define ETFs.

ETFs are exchange-traded funds, which have all the characteristics of a mutual fund, except they trade on a stock exchange like any other security.

A good reason to invest using ETFs is that they’re cheap to own.  They only charge around 0.20% per year, because ETFs aren’t actively managed.  And they certainly don’t charge an assets-under-management (AUM) fee or a performance fee like hedge funds do. 

ETFs are a great addition to most investor portfolios, as you can cheaply buy “the market.”  

That is, you can buy ETFs on the following things:

  • Bonds
  • Bitcoin
  • Commodities
  • Equities
  • Money Markets
  • Multi-Asset
  • Precious Metals
  • Real Estate

The list is almost endless.  As of the end of 2020, there were 7,602 ETFs managing over $7 trillion of assets.

For assets such as equities and bonds, they’re just fine.  For example, the SPDR S&P 500 ETF (SPY) tracks the index and is the largest ETF with nearly $330 billion in assets.

The QQQ tracks the Nasdaq; the TLT covers U.S. Treasuries; the HYG covers high yield or junk bonds.

Of course, you can also buy sectors of the market, such as tech, healthcare, and pharmaceuticals, to name a few.

There are also commodity ETFs, which, for reasons I’ll get into presently, are mostly crap.

One Drunken Night in a Club

At my last banking job, I was at an offsite in Taipei.  One evening, over a bottle of champagne at a dance club, I was talking to a managing director about how I thought oil was going to explode higher.   I didn’t want to buy futures – as a former futures broker I knew how risky that could be – so I was thinking of buying the USO (United States Oil Fund) instead.

With a look of solemn despair and warning, he said, “Never do that.  You must understand how most of these commodity funds are structured.  You know what happens when markets are in contango.  The roll yield will kill you.”

I’m going to parse out that warning for you.  It’s amazing how some side conversation on the ass-end of the world can save your portfolio.

How are Commodity Funds Structured?

If you’re intent on investing in commodity funds, this is the first place you must do a bit of homework.  The question you must answer is this: “Does this fund use the actual underlying asset to create the fund, or does it replicate ownership using futures contracts?”

If it’s using the actual asset, fine.  You can proceed.  (For example, GLD, the SPDR® Gold Shares, is the largest physically-backed gold ETF in the world.)

But if it’s using futures contracts, it’s a no-go.  Let me tell you why.

Let’s very quickly define futures contracts.  Futures are a standardized obligation to buy or sell a specified quantity of a standardized asset at a price agreed today for delivery in the future.

For example, the WTI oil futures contract is an obligation to buy or sell 1,000 barrels of West Texas Intermediate oil at the price you agreed today (say, $64.90) for settlement in the month you bought or sold (say, May 2021).

The issue with futures contracts is that you need to roll them.  They just don’t last that long.  That is, they mature every month.

For instance, before the May 2021 contract matures May 31, 2021, you need to “roll” into the June 2021 contract.  Then before June 30, 2021, you need to roll into the July contract.

This can get very expensive, not because of the commissions – which are minuscule nowadays – but because of the difference between what you can sell the May contract for and buy the June contract for.

That leads us to two more important terms.

Contango Isn’t a Dance; Backwardation isn’t Reversing Your Car

As Socrates stated almost 2,500 years ago, “The beginning of wisdom is the definition of terms.”  And boy, does the financial world throw up some doozies!  So let’s get these two esoteric terms defined.

Contango simply means the futures price of an asset is greater than the spot or cash price of the asset.  Although a futures price is not a prediction, contango usually occurs when price rises are expected over time.

Cantango

Backwardation is the opposite of contango.  That’s when the spot price of an asset is greater than the futures price.

Backwardation

I have no idea how they came up with these terms.

Never mind, because the important part is the roll yield.  “Yield,” in finance, is synonymous with “return.”   (We usually use “yield” in fixed income and commodities, and “return” with equities, but there are exceptions.)

The roll yield is the amount of return generated after an investor rolls a short-term contract into a longer-term contract.  The managers of commodity funds have to do this every month to attempt to mimic the underlying asset.  Unfortunately, it doesn’t work out like that.  The roll yield is the reason.

Most futures markets are in contango.  As futures prices aren’t a prediction, the reason why they’re higher is because of the costs associated with storage, insurance, and foregone interest.  All are a function of time.  So the longer out you go, the more expensive the contract is.

Since most futures are in contango, the commodity ETFs based on them lose big money on the roll yield, despite the spot and futures prices going up!  That’s because they’ve got to roll every month, and the farther out contracts are more expensive.

To get a feel on just how often a roll yield is negative, look at this, from WisdomTree:

negative roll yield

The roll yield is almost always negative!

The exception is the backwardated market.  That happens during supply squeezes, a heavy increase in demand, or times of war.  It’s when buyers want that asset right now, and will pay more for it.  Think China buying wheat during a drought, or buying copper when they want to wire up an entire ghost city.  Or America invading the Middle East, driving up oil prices.

But this doesn’t happen all that often.  And if it does, it’s difficult for an investor to notice it.

Interestingly, the WTI is in backwardation at the moment.  And USO has rallied considerably since the disastrous Saudi-Russian oil standoff in 2020.  But to assume that will continue indefinitely is foolhardy.  The curve can flip from backwardated to contango at any moment.

flip the curve

So the real worry is not what the underlying price of oil does.  It’s whether or not the futures curve stays in backwardation.

I think there are far better ways to spend your time.

Alternatives to Futures-Based Commodity ETFs

Trading the Futures Themselves

First, you can trade the futures themselves, but they come with all sorts of risks.  Not my first choice unless you have millions of dollars in the bank already.  And you’ve got the kind of mentality that can handle daily losses.

Buying Commodity Company ETFs

But you can invest in the ETFs of companies whose main business is commodities.  If you like gold, you can look at GDX or GDXJ.  If you like oil and gas, you can look at XOP or IEO.

Please keep in mind that I’m not recommending these ETFs.  I’m only giving you an idea of what you can do, given your view.

Buying the Commodity Companies Themselves – The Pure Play

If you prefer single stocks and think you have an edge, you can always buy the company stocks themselves.  ETFs provide diversification while also giving you exposure to a sector.  But if you think a single stock will do the job for you and are willing to take the risk, this is your play.

For oil, this may be Exxon (XOM) or Chevron (CVX).

For gold, this may be Barrick Gold (GOLD) or Franco Nevada (FNV).

Again, you must do your research when undertaking these kinds of investments.

Just remember, the first thing you must do is preserve your capital.

Well, that’s all I’ve got for now.  I wish you an absolutely rocking week ahead!

All the best,

— Sean

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