Why This Oil Fund (USL) Is The Pick Of The Bunch
Jan 28th, 2009 | By Matt Weinschenk | Category: Featured‘Contango’ has become a buzzword of late. But Matt Weinschenk says you must be careful how you position yourself to profit in the oil market. The most popular oil sector ETFs (USO, OIL) actually suffer in today’s market conditions. Matt says the United States 12 Month Oil Fund (NYSE:USL) is a much better way of maximising the return on your oil investments.
This from Investment U:
You might think you’re properly invested in oil, but you could be wrong.
Despite reaching lows since 2004, the long-term outlook for oil is still up. Maybe not $147 a barrel like the old days (i.e. six months ago), but because of supply, demand, turmoil in the Middle East, and the fact that we will eventually resume worldwide economic growth, oil prices have only one way to go.
If you think you’ve positioned yourself according, or if you’re thinking about a new investment in oil… tread carefully. Here’s why:
I covered a situation last week call contango. It’s a feature of futures markets where you can buy oil cheap right now and lock in a contract to sell it in the future for a higher price. Normally, the difference between those prices is so close to the cost of storing the oil that it’s not a profitable trade.
But right now, we’re in a state of super-contango. Prices are way out of whack. And commodity investors are storing oil everywhere they can to earn the excess profits. (For a more detailed description, see contango.)
Contango is big news now. But some of the “traditional” oil investments that are being tossed around aren’t what they seem to be. In fact, if you skipped some very fine print, you could have set yourself up for a huge disappointment.
So let’s clear that up… and pad our pockets with a little extra in the process.
You’re Not Buying What You Think You’re Buying
When we broke the news on contango, we suggested looking at some oil storage providers, explorers and drillers. And that hasn’t changed. Looking around, there are a number of “oil investments” that look promising.
One would think the quickest way to invest in rising oil prices would be to simply buy shares of an oil-based ETF, like United States Oil (NYSE: USO). These oil ETFs are very popular – USO trades over 34 million shares per day.
But not so fast.
These funds don’t buy and sell oil for profit. They trade futures contracts on oil. And while there are a few ways to do that – some good, some bad – they may not be the best way to take advantage of contango. Let me explain.
USO buys a contract for oil for the very next month. Before it expires, they sell it off and buy one for the next month. In a contango situation the returns will indisputably be lower. (Conversely, during the opposite of contango, “backwardation,” the fund returns will be higher).
USO makes no secret of this. They print it in their risk disclosures that contango is not good for their fund.
And they are not alone. The iPath GSCI Crude Oil ETN (NYSE: OIL) and the Powershares DB Crude Oil ETN (NYSE:OLO) use the same methodologies. (Though OLO actively manages its roll forward strategy to reduce losses.)
But don’t give up on investing in oil.
Every Problem Has a Solution
In fact, the same manager that runs the USO fund runs another, custom designed to benefit from situations like this. It’s called the United States 12 Month Oil Fund (NYSE:USL). It uses a 12-month average of futures prices that will lessen the losses caused by a contango market.
Here’s the interesting thing. Oil markets usually exhibit a small amount of contango, it’s a natural result of price fluctuations. But its opposite, backwardation, is the rarity. So even if we were in a normal oil situation, wouldn’t the 12 Month Fund be better?
In fact, wouldn’t it make sense all the time? It would seem to be so.
Obviously, oil prices have been down… but you’d have fared significantly better investing in USL. Reading the fine print on an ETF isn’t the most entertaining way to spend your day, but it’s certainly worth a near 15% difference in performance.
If we were to enter a backwardation period, USO would then outperform. But since backwardation is so rare… you can expect USL will outperform consistently over the short and long term.
Source: The Wrong Way to Profit From Oil
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What do you think of this article on USL that your think is a better choice,
See this paragraph on it below:
At a time when initial public offerings and other investment-banking business is scarce, Wall Street is all too happy to assist in rolling out a steady stream of ever narrower ETFs, notes Reilly, who formerly headed up equity compliance for Goldman Sachs. Not all of these products work as promised. Example: the United States Oil Fund. The ETF purports to track the price of West Texas intermediate crude oil. It also pays out $1 million a month to lawyers, auditors, outside directors and regulatory overseers.
Reilly thinks the ETF is a disaster for the investors picking up the tab because it buys futures in a bid to track a thin underlying market. The result is that professional traders front-run it each month in the pre-announced couple of days before the ETF rolls over its positions into the new front month. USO’s highly paid outside professionals don’t seem to mind.
“It’s like trading with your pants down,” says Reilly. “But would a lawyer really say to her client ‘This ETF might not be the best idea because of x, y and z’ when her firm stands to make tens of thousands of dollars a month on it?”
How To Avoid ETF Pitfalls
David K. Randall 04.29.09, 12:00 PM ET
When exchange-traded funds were introduced in 1993, they were one of the greatest innovations for long-term investing in decades. A class of mutual funds that trade throughout the day like stocks, “Better than Mutual Funds” is how we described them in one headline.
Early on, ETFs mostly parroted broad benchmarks like the S&P 500 for rock-bottom fees and with excellent tax efficiency. The fanciest ones did nothing more exotic than break down the indexes into a handful of component parts–consumer staples, health care and financials, for example.
Times have changed. There are currently 850 ETFs vying for a piece of a $450 billion market. They still offer easy access to markets, but these days that access often seems to benefit Wall Street sharpies more than Main Street investors. In fact, many of the cardinal sins of financial excess seem to be part-and-parcel of the ETF business these days: extreme leverage, market manipulation and tax bills that can blindside unsuspecting investors, to name a few.
What happened? The age-old story of a good idea taken to excess. ETFs make it so easy to track a market, or a narrow sliver of it, that Wall Street has taken tracking to absurd lengths. You could, for example, buy the iPath Dow Jones-AIG Lead Total Return Sub-Index or PowerShares DWA Emerging Markets Technical Leaders. Even Vanguard, typically a bastion of common sense, offers 18 ETFs that go so far afield as to track energy and non-U.S. small caps.
“You can create an exchange-traded fund off of almost anything,” says James Reilly, founder of Lex Sequor Consulting, a regulatory compliance consulting firm.
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At a time when initial public offerings and other investment-banking business is scarce, Wall Street is all too happy to assist in rolling out a steady stream of ever narrower ETFs, notes Reilly, who formerly headed up equity compliance for Goldman Sachs. Not all of these products work as promised. Example: the United States Oil Fund. The ETF purports to track the price of West Texas intermediate crude oil. It also pays out $1 million a month to lawyers, auditors, outside directors and regulatory overseers.
Reilly thinks the ETF is a disaster for the investors picking up the tab because it buys futures in a bid to track a thin underlying market. The result is that professional traders front-run it each month in the pre-announced couple of days before the ETF rolls over its positions into the new front month. USO’s highly paid outside professionals don’t seem to mind.
“It’s like trading with your pants down,” says Reilly. “But would a lawyer really say to her client ‘This ETF might not be the best idea because of x, y and z’ when her firm stands to make tens of thousands of dollars a month on it?”
ETFs are still a great way to invest for the long haul. But only if you stick to buying and holding onto a few broad market indexes. Or, if you’d prefer to harvest losses on a portion of your portfolio along the way to reduce the tax burden of rebalancing, buy five to 10 sector indexes that approximate the broader market. Then sell losers to lock in the tax advantages and limit your other trading to rebalancing.
Go much further afield, and you’ll quickly wander into the ETF equivalent of the Wild West. Trespassers often get bushwhacked by one or more of the following:
Narrow and Mislabeled ETFs: Like U.S. Oil, many ETFs these days are trying to create robust businesses out of thin air and have to make costly, or misleading, compromises to do it. With green energy the rage, along have come First Trust Global Wind Energy and PowerShares Global Wind Energy. Since the wind-investing world isn’t all that large, the ETFs each recently tucked among their holdings the un-green oil outfits Royal Dutch Shell and BP. Why? Owning greenhouse gas bags lowers the ETFs’ volatility and provides liquidity, explains Paul Justice, a Morningstar analyst who covers ETFs.
“Wind power is about as important to [these companies'] overall returns as frog legs are to a balanced diet,” he says.
Solar power ETFs Market Vectors Solar Energy fund and Calymore/MAC Global Solar Energy go by the cutesy tickers KWT and TAN. Along with the infrastructure funds Materials Select SPDR and iShares DJ Basic Materials, they likewise include large holdings of little relevance to their purported mandates, Justice says.
Lotsa Leverage: It sounds like a promising idea: Buy an ETF and get double or triple an index’s return on the way up or down. That was good enough to boost assets in leveraged ETFs from $9 billion to $24 billion between January and February of this year alone, according to State Street Global Advisors.
Gloss over the fine print, however, and you’re likely to be in for a nasty surprise. Virtually all of these leveraged funds use swaps to track daily returns. Hold them for more than a day and your return can dramatically lag the underlying index.
Justice, the Morningstar analyst, figures funds that use leverage or go short are appropriate for the less than 1% of investors. For the rest, they can be a disaster. Last year, anyone holding either the double long Ultra Oil & Gas ProShares (DIG) or the double short UltraShort Oil & Gas ProShares (DUG) would have lost money as the price of oil spiked and collapsed. The long fund fell 69% and the short one 19% for the year.
“If you’re hell-bent on using leverage for longer than a day, use a margin account” and stick to equities, suggests Justice.
Fund firms are unbowed and say they’re giving professional investors what they want while making efforts to educate others. “We want people to understand the products, and if they’re not sophisticated, they should get a financial advisor for investments like this,” says Michael Sapir, chief executive of ProShares.
Tax Traps: Another misconception among investors is that all ETFs are classes of mutual fund shares and taxed as such. Even if that were so, what matters to the IRS is not just a fund’s structure but also its underlying assets.
Many ETFs that own futures are actually limited partnerships. That includes United States Oil and the PowerShares DB Commodity Index Tracking Fund. Sit on their shares, and you’ll be taxed on the funds’ internal trading activities, with 60% of gains subject to long-term capital gains rates and 40% to short-term rates.
Many commodity ETFs are structured as grantor trusts, Justice says. Own one that holds physical metals, like SPDR Gold Shares or iShares Silver Trust, and you’ll be taxed on the sale at ordinary income tax rates.
Leveraged ETFs are also a tax minefield. No matter how long you hold them, the IRS regards gains as short-term because of the daily swaps that produce them. Another problem: If other investors decide to redeem their shares en masse, the manager will be forced to unload derivatives used to track the benchmark and pass on any gains. If you’ve been in the shares for less than a year, the IRS will regard your distributions as a tax-free return of capital. Longer-term investors will get stuck for the short-term capital gains rate.