A Gusher of a Bad Idea

April 28, 2006

A lot of good has come out of the exchange traded fund (ETF) revolution. ETFs have drawn billions of hot money dollars out of ordinary mutual funds, helping longer-term mutual fund investors’ returns by giving the fund manager a more stable asset base. ETFs are more tax-efficient than ordinary mutual funds. Even better, low-cost ETFs have put some pressure on fund fees.

But all is not rosy with ETFs. Like the opening of a riverboat casino near your home, ETFs give investors new opportunities to gamble. The average holding period for an ETF is measured in days, not years like with ordinary mutual funds.

A fresh trend in ETFs is giving investors a way to speculate on individual commodities. These commodity ETFs have full exposure to commodities directly or through futures contracts. Traditionally, commodities are physical items like food, grains, lumber, metals, and fuel – the generic building blocks of an economy. More recently the definition includes anything that trades on a commodity exchange, including currencies, financial instruments and indexes.

The most successful example of the new commodity ETFs is the StreetTRACKS Gold Shares fund (ticker GLD), launched in early 2004. The fund has attracted over $7 billion in investor assets, making it one of the ten largest ETFs.

A much anticipated, silver-focused ETF is due out soon. Earlier this year the Deutsche Bank Commodity Index Tracking Fund (DBC) was offered. This ETF is a slightly more diversified way to buy commodities and it owns futures contracts on Light, Sweet Crude Oil, Heating Oil, Gold, Aluminum, Corn, and Wheat.

The new U.S. Oil Fund ETF (USO) is trading almost a million shares a day (or about $70 million worth changing hands) mere days after launch. For reference, and a clear sign of how the speculator tail is wagging the economy dog, the U.S. imports about $800 million dollars worth of oil a day.

One thing is for certain: just about any diversified stock fund will beat this new ETF over the next ten years. Recent history aside, commodity investing is a disaster for most investors.

Here is why you can't win betting on commodities:

1) Commodities are a zero-sum gain. Unlike stocks and bonds, there is no wealth transfer from the investment to the owner, now or in the future. For you to make money in oil futures, somebody else has to lose money.

2) Other people know more than you. Billion-dollar hedge funds and oil companies trade oil futures daily. They tend to win more than you. Even if their predictions for oil are just as flawed as yours, they will beat you because the game is slanted in their favor. Oil companies control production and have a better grasp of supply and demand issues than you do, and leveraged, billion-dollar hedge funds can create self-fulfilling spikes up and down in oil by their own trading. Hedge funds also have access to better information and employ ex-oil company traders to work for them. Do you think in a zero-sum game you can beat a BP oil trader on the other side of the contract you just bought?

3) Inflation is a bad long-term return. Many futures market participants are just trying to hedge away the risk of their own production or lock up supply for future needs – the real reason futures markets were setup in the first place. The primary rationale for individuals owning commodities is to hedge against inflation, not lock in a price for oil they will drill out of their own backyard next month. Unfortunately, inflation is a mediocre return and is easy to beat. Any major asset class (real estate, stocks, bonds) will at least match inflation over very long periods of time, and generally will beat it. Gravel will match inflation over time. A Vanguard money market fund is a near perfect, no-risk inflation hedge. You’ll at least match inflation over the long haul with a low-fee money market fund, as the sort of investments these funds buy have yields that move with inflation most of the time.

4) Carry costs will eat into inflation return. This fund costs 0.40%. That’s on top of the high trading costs of rolling over futures contracts every few months. This digs into your low inflation-linked returns. While this fund is easier and cheaper than buying actual oil futures for most investors, it still has ongoing costs. Just like Vegas, only you have to pay for your drinks.

5) When you think a commodity is a good idea, it is probably very near the end of move up. The fact these kinds of funds are even getting launched is a bad sign. You could make the case for a gamble on commodities back in 2000 when everybody was hopped up on new-economy riches and anything old-economy was dead (including oil stocks). As the long-term return on commodities is roughly the inflation rate, it’s likely that hopping in after a stretch of inflation-beating returns will be followed by negative returns. At best, commodities are a short-term speculation on inflation picking up (or just inflation fears) or a gamble on some supply disruption in the future.

The long haul returns look bad. Forget about the inflation-adjusted losses anyone who bought oil or gold during the peaks a few decades ago would still be showing today; returns from ordinary levels are still poor.

If you stuck a barrel of oil in your garage back in 1950 and sold it today, you’d be up 20x on your money ($3 to $60). Of course, if you parked a brand new 1950 Cadillac next to the oil and didn’t touch that either, it could be worth about 20x as much as well ($3,000 then, $60,000 today if mint/undriven). Gold was about $35 an ounce in 1950, offering a similar return to the Caddy. Bottom line, any hard asset will move more or less with inflation over the long haul. The less manufactured the product, the closer the relationship (steel bars vs. cars).

Keep in mind that your home could easily have climbed 50 times in value, your stock portfolio 100 times over the same time period.

You’ll never reach your retirement goals simply matching or “keeping up with” inflation. Worse, the potential for buying high and selling low with commodities is higher than with stocks, bonds and real estate. Commodity-linked investment “opportunities” don’t get launched (and draw in big money) when commodity prices are low. They get launched when everybody thinks it’s a brilliant idea. Nobody wanted to buy oil futures when oil was $10 a barrel in 1998. Now that oil is around $70 a barrel investors are lining up.

If you want to make money in commodities, write a book about commodity investing, or better yet, launch a commodity fund. On that note, the person who launched this oil ETF manages a regular stock mutual fund. In that fund he is underweight energy stocks compared to the S&P500.

Apparently, selling oil-related investments is smarter than investing in them right now.