Minding the ETF Gap
ETFs are a popular investment vehicle for investors who want exposure to a simple underlying asset like an equity index or a commodity. At the time of writing, the United States Oil Fund (USO) is the 8th most traded ETF in the world, with assets under management of $2.8 billion and average daily volume of 28.5 million shares.
However, investors that buy into USO hoping for exposure to the price performance of crude oil are in for a nasty shock. The below chart shows the relative performance of the front month benchmark WTI Crude Oil contract (CL on NYMEX) and the USO ETF.
From a low of $26 in Feb 2016, the price of crude oil has recovered to $46, or an increase of 77%. USO on the other hand, from a low of $8, has increased to $9.5, only 19%. Why the massive discrepancy?
To answer this question, we must dig in to exactly how USO gains exposure to the price of oil. The ETF manager does not simply buy barrels of oil and put them in storage. From the USO website:
"USO invests primarily in listed crude oil futures contracts and other oil-related futures contracts..."
"USO's Benchmark is the near month crude oil futures contract traded on the NYMEX..."
Now we're getting somewhere. The benchmark WTI NYMEX contract (CL) lists expiry dates every month. Under normal market conditions the crude oil market is in contango. This means that contract dates further in the future are priced higher than near term contracts. The current front-month contract, July 2017, is trading at $46.30 while the next contract, August 2017, is trading at $46.50, a premium of $0.20. USO tracks the front-month performance by buying and selling July futures as demand for the ETF rises and falls. However, when the July contract expires, the ETF must roll their holdings into the next month. This means that they must sell July contracts, and simultaneously purchase the same number of August contracts at a premium of $0.20. Every time the ETF manager rolls the position they take a loss equal to the premium, every single month.
For short term traders the contract roll is not an issue. The stated purpose of USO is to track the daily percentage changes in crude oil prices, and so long as the same contract month is bought and sold this objective is met.
"The investment objective of USO is for the daily changes in percentage terms of its shares' NAV to reflect the daily changes in percentage terms of the spot price of light, sweet crude oil..."
However, investors taking a long term view on the price of oil pay away the roll premium every month. This is the cause of the massive discrepancy when comparing the performance of CL and USO. The CL chart displayed above is actually a composite of different front-month contracts stitched together. Alternatives solutions are buying a single futures contract with a longer expiry date, or physical barrels of oil. However both of these approaches present capital requirements and logistical costs that the average ETF investor seeks to avoid. Buyer beware, mind the futures roll gap when trading commodity ETFs.
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-Instructor at How Markets Work