Use Caution When Trusting The Returns Of Oil ETFs

In the financial world, the price of crude oil is tracked almost as closely as the day-to-day fluctuations of the S&P 500 Index. This liquid commodity is essential to so much of the global economy that investors are continually try to forecast its direction and what it entails for other investment classes.

Investing directly in the oil markets used to be the realm of big-money traders with access to the futures markets. However, the introduction and wide spread adoption of exchange-traded funds (ETFs) that track these contracts has made the ability to invest in oil more mainstream.

The largest ETF in this class is the United States Oil Fund (USO), which has $2.78 billion dedicated to tracking the daily price movement of West Texas Intermediate ("WTI") light, sweet crude oil. This is one of the largest and most heavily followed of all the differing types of oil futures.

USO essentially invests in the front-month WTI futures contract and then rolls their underlying holdings to the next month at a pre-determined point in time. It sounds like an easy and automated process, but this continual rebalancing to a new underlying security classification creates tracking inefficiencies that are noticeable over time. This performance gap is also further exacerbated by the management fees and other associated costs of holding a commodity-linked fund.

The chart below highlights the differing performance characteristics of USO versus the benchmark West Texas Intermediate Crude Oil Continuous Contract ($WTIC) over a three-year time frame.

This same performance gap is notable in other funds that track the oil markets as well. The iPath S&P GSCI Crude Oil Total Return ETN (OIL) and PowerShares DB Oil Fund (DBO) are two examples of alternatives in this category. Both suffer from similar price patterns and high costs relative to a passive index of traditional stocks or bonds.

This type of tracking error is one that has plagued commodity funds for years and underscores a key dilemma facing ETF investors. Namely, should we still consider these vehicles effective investments even if they fail to capture every tick in the oil markets?

The answer can vary for each type of investor based on their time horizon and risk tolerance. Those who decide to purchase an ETF linked to the oil markets must be aware of the potential tracking issues beforehand to avoid buyer’s remorse. These vehicles are likely more adept at capturing shorter-term moves than serving as a long-term holding within a diversified portfolio.

It should also be assumed that these funds are more aggressive by nature in that they invest in speculative futures contracts of a single commodity rather than the broad exposure of a conventional ETF.

Furthermore, the legal structure of a commodity-linked fund should be examined before purchase. These ETFs are generally organized as limited partnerships to participate in the futures markets instead of a trust. This means that every shareholder is considered a limited partner and is subject to a K-1 tax form at year-end rather than a traditional 1099. This may create unintended tax consequences for non-qualified accounts that own an ETF like USO.

The Bottom Line

The unique nature of commodity ETFs creates varying risk dynamics that must be considered prior to jumping headlong into these investments. While they can be tempting trading vehicles, their usefulness as long-term holdings has questionable benefits given the decay of rolling futures contracts and above-average expenses.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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