Like so many investors in the spring of 2009, Gordon Wolf needed to dig out of a hole. A 68-year-old psychologist in Napa, Calif., Wolf was a buy-and-hold sort of guy, yet the nest egg he had entrusted to his broker at Merrill Lynch was down more than 50%. The broker had invested much of it in exchange-traded funds, or ETFs, a financial innovation that was replacing mutual funds in the hearts and portfolios of many investors.
An ETF, which can be bought or sold like a stock, attempts to track the price of a particular basket of assets -- tech stocks, for instance, or high-yield bonds, or commodities ranging from wheat to gold.
The commodity ETFs were supposed to offer a hedge against equity losses, but in the crash of 2008, everything fell in tandem. As oil declined to $34 a barrel in early 2009, Wolf sensed an opportunity. He called his broker and asked about U.S. Oil Fund (USO), an ETF designed to track the price of light, sweet crude. Wolf had the broker buy about $10,000 of USO.
Investors by the end of 2009 had put a record $277 billion in commodity ETFs and other securities linked to raw materials -- a huge jump from $5.5 billion a decade earlier, according to Barclays Capital. During that time, Wall Street had transformed the reputation of commodities from a hypervolatile investment that can steal your shirt to a booster for battered portfolios, something that rose when stocks fell and hedged against inflation.
People who would never think of buying a tanker of crude oil or a silo of wheat could now put both commodities in their 401k's. Suddenly, everybody was a speculator.
And some were losing big. The commodity ETFs weren't living up to their hype, and the reason had to do with a word Wolf had never heard. As he browsed the blogs, he says, "I'm seeing people talking about something called contango. Nobody would define it."
Wolf called his broker and asked about contango. "I don't know what it is," he replied.
Wolf called his other broker, at Charles Schwab (SCHW, news, msgs). "He didn't know either," he says. "He said he'd ask around."
Weeks later, after Wolf educated himself, he fired his Merrill broker and pulled out his money. (Merrill and Schwab declined to comment.) By then he had lost $2,500 on USO. "If it wasn't a rigged game," he says, "I could figure it out. But it is a rigged game."
The contango trap
Contango is a word traders use to describe a specific market condition, when contracts for future delivery of a commodity are more expensive than near-term contracts for the same stuff. It is common in commodity markets, though as Wolf and other investors learned, it can spell doom for commodity ETFs.When the futures contracts that commodity funds own are about to expire, fund managers have to sell them and buy new ones; otherwise, they would have to take delivery of billions of dollars' worth of raw materials. When they buy the more expensive contracts -- more expensive because of contango -- they lose money for their investors. Contango eats a fund's seed corn, chewing away its value.
Contango isn't the only reason commodity ETFs make lousy buy-and-hold investments. Professional futures traders exploit the ETFs' monthly rolls to make easy profits at the little guy's expense. Unlike ETF managers, the professionals don't trade at set times. They can buy the next month ahead of the big programmed rolls to drive up the price, or sell and push down the price investors get paid for expiring futures. The strategy is called pre-rolling.
"I make a living off the dumb money," says Emil van Essen, the founder of an eponymous commodity trading company in Chicago. Van Essen developed software that predicts and profits from pre-rolling. "These index funds get eaten alive by people like me," he says.
A look at 10 well-known funds based on commodity futures found that, since inception, all 10 have trailed the performance of their underlying raw materials.
The biggest oil ETF, the U.S. Oil Fund, which has $1.9 billion invested in it, has dropped 50% since it started in April 2006, even as crude oil climbed 11%. The $2.7 billion U.S. Natural Gas Fund (UNG), offered by the same company, has plummeted 85% since its launch in April 2007, more than double the 40% decline in natural gas.
Deutsche Bank's PowerShares DB Agriculture Fund (DBA) has eked out a 3% total return since January 2007, while the weighted average of its commodity components has risen 19%. To be sure, those spot prices -- reported on cable business channels and other outlets -- set an unreachable benchmark. If investors try to match the spot market using ETFs, they can get killed by contango. If they dodge contango by buying physical commodities instead, they must pay heavy storage costs that can easily turn gains to losses.
The allure of commodity investment has hit even big investors. The California Public Employees' Retirement System, the nation's largest public pension, has lost almost 15% of an $842 million investment in commodity futures since 2007, depriving it of income at a time when it has sought taxpayer money to cover retiree benefits. It defends the investment as insurance that will pay off in the event of inflation.
Continued: 'Very, very good for Wall Street'
