Commodities: Uncertain Futures

Investors who have grown comfortable with stock index funds over the years are piling into funds that track commodity indexes—to the tune of an estimated $200 billion worldwide. To capitalize on that demand, a host of new and, their creators say, improved products that track commodity indexes are being launched. But whether long established or newly minted, the commodity index fund is a very different animal from its equity cousin. Investors who don't understand that may be in for a rude awakening when the commodity boom ends.

Perhaps no one cares right now that the PowerShares DB Oil (DBO) exchange-traded fund (ETF) is up 106% over the past year while the United States Oil Fund (USO) is up 115%. What's a nine-percentage-point difference when you have triple-digit gains? But it must strike attentive investors as odd that two funds with identical management fees that ostensibly invest in the exact same thing--light sweet crude oil--have such a performance gap. It's not as though they're buying different stocks. Oil is oil, right?

Well, not quite. These funds aren't investing in oil directly but in oil futures--contracts that are a bet on the price of oil in the future. And just how funds place and manage those bets can make all the difference in returns.

Here's why: Futures have two other things driving their performance besides the commodities they track. Since futures are bought largely on margin, funds must set aside liquid bonds or cash as collateral against potential losses. Interest earned on collateral is added to a fund's return. Collateral is often made up of short-term Treasury bills or cash, but some funds (Pimco is one) use slightly higher-yielding bonds, which can boost their returns.

Of far more consequence for returns is something called "roll yield." It's the positive or negative return a manager gets when he sells one futures contract or rolls an expiring contract into a new one. Futures are more like bonds than stocks in that they have maturity or expiration dates. When you buy an oil future you are not buying today's price of oil--what's known as the "spot price." You're buying what investors think the price of oil will be a month from now, two months, a year--whenever the contract expires. The difference between buying near-term futures or longer-dated ones can have a big effect on roll yield, and thus returns.

TAKING A LONGER VIEW

The older commodity indexes invest mostly in futures with the shortest maturity dates. The logic: They tend to be easier to trade and closely reflect current prices. "Oil shocks and other unexpected price movements tend to have the greatest impact on the shortest-dated futures that are closer to the spot price," says Eric Kolts, commodity indexes product manager at Standard & Poor's (MHP). And oil shocks are usually positive for oil investors, if not for consumers. The S&P GSCI Index invests mainly in one- or two-month futures.

But creators of what are being called "second-generation" commodity indexes say that buying just short-dated futures is short-sighted. "Would you only invest in three-month Treasury bills to get a diversified bond portfolio?" asks Kurt Nelson, head of U.S. commodity index marketing at UBS (UBS). "Probably not, but that, in effect is what the older commodity indexes are doing." This April, UBS launched a slew of exchange-traded notes (ETNs) called E-Tracs that track commodity indexes by buying futures that range from three month to three years. (ETNs are bonds whose performance is usually linked to a benchmark index.) UBS thinks a more diversified approach will increase returns while reducing volatility.

To determine how its new strategy would perform, UBS back-tested it, running computer simulations using historical market data.

Speculation_but Not Manipulation

Are Pension Funds Fueling High Oil?