The Problem With the Oil ETF: It Does a Great Job
The sudden sell-off in oil on Tuesday has added insult to injury to many investors in the United States Oil Fund (USO).
“Injury” is actually the perfect metaphor, because exchange-traded funds like USO are a lot like power tools. In the hands of a pro, they can be a huge help. Used by a novice, they’re a disaster waiting to happen.
On one hand, USO is a good product that does exactly what it says it’s going to do: track near-month futures contracts on WTI crude oil. As such, it has a 95 percent correlation to daily moves in spot oil. For example, oil was up 4.6 percent last Thursday and 5.2 percent last week. Meanwhile, USO was up 4.2 percent and 5.1 percent, respectively. Pretty good, right? This ability to efficiently capture moves in spot in an equity-like trading vehicle at a penny spread is why many smaller trading firms and hedge funds love to trade this thing. To them, it’s a godsend.
But being good at tracking near-month oil futures is the same reason USO is horrible at tracking spot oil over the long term. Oil is up 21 percent this year, yet USO is down 6 percent. What a nasty surprise this will be for many retail investors: They made the right call on oil, yet lost money.
Why is this? How come it won’t just track oil over the long term?
It’s complicated, but mostly it’s because it’s a huge pain to store oil -- unlike, say, gold or silver. Not only is it expensive, it’s very dangerous. This “cost of storage” is priced into the futures curve as seen below. So as the near-month contract nears expiration, USO must sell it and buy the next month out, which is normally more expensive. Do this multiple times, and you can understand why it’s lagging oil by 27 percentage points this year.
While we can never be 100 percent sure who is using USO (since ETF trading is anonymous), there’s data to suggest it’s being used -- and misused -- by retail investors. First, only 20 percent of its holdings are accounted for in 13Fs, which is the name of the holdings report filed by big institutions.
Second, only about 11 percent of its assets trade each day. This “turnover” is much lower than other power-tool-type ETFs. For example, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) has turnover of 63 percent a day.
A good rule of thumb is that the more an ETF’s assets turn over, the more institutions are trading it. This is why you’ll see many leveraged ETFs turn over more than 30 percent a day, such as the VelocityShares Daily 3x Long Crude Oil ETN (UWTI). On the flip side, a typical Vanguard ETF turns over less than 1 percent each day. USO should be closer to VXX and UWTI than Vanguard. And it isn’t.
All this shouldn’t be news for anyone because the same thing happened in 2009, the last time oil had a big rebound. Everyone rushed in to buy USO, pushing its assets up to $4 billion at one point. At the end of the year, crude oil was up 77 percent. USO returned a measly 14 percent.
It’s probably being used by investors who were lured in by an ETF whose name sounds like a perfectly good way to play oil. I wonder how many people would have stayed away if it were called the “United States Oil Plus Crippling Roll Costs ETF,” or if it had a parental advisory warning sticker.
While ETFs are a net positive for investors -- and have arguably democratized investing -- they bring along some real dangers. Just because the wrapper is pretty doesn’t mean what it holds is. If there’s a takeaway, it’s this: If you wouldn’t be comfortable buying what the ETF holds, then you may want to think twice before buying the ETF.
The normal state of oil futures can reverse if the oil market has a sudden shock and demand spikes. In those cases, the curve often inverts and the ETF can actually profit from rolling.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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