ETF Prime Archive

A Primer on Energy ETFs

This week we’ve fielded calls requesting information and guidance regarding ETF coverage of energy commodities. And while the entire commodity arena warrants attention, for the sake of brevity, we’ll limit our discussion here primarily to the energy segment.

Most any form of commodity exposure that the individual and institutional investor would need is currently available in the form of an ETF. And there’s more in the SEC registration pipeline that will provide additional granularity through a broader menu of single commodity ETFs during the coming months.

Commodity ETFs can be grouped along three primary lines: energy, metals and agricultural.

The most developed of the three, selection-wise, is energy. Exposure can be had across all three segments via a single ETF or can be tailored by the investor via the use of single ETFs covering individual commodities or commodity subclasses.

Construction-wise, (un-leveraged, long) commodity ETFs purchase short-maturity treasuries which are then used to collateralize ownership in commodity futures positions. Among alternatives covering a given commodity, there are important differences in how expiring futures positions are rolled to forward futures positions. This is not an issue for two of the gold ETFs, which directly hold physical gold.

Deutsche Bank Commodity Index Fund (DBC), marketed through Powershares, is 55% energy (35% crude, 20% heating oil), 22.5% metals (precious at 10% via gold, base at 12.5% via aluminum) and 22.5% agricultural (11.25% for each of wheat and corn). The fund is rebalanced back to these weightings once per year in November.

The players in energy ETFs are US Commodity Funds LLC and Deutsche Bank (DB). Energy exposure can be taken in the form of a multi-commodity ETF, comprised of refined and unrefined components, or via single commodity ETFs.

DB Energy Fund (DBE) is a mix of crude oil (45%), refined oil products (45%) and natural gas (10%). The crude component is split between WTI and Brent at 11.25% each. The refined is split between heating oil and RBOB gasoline, likewise at 11.25% each. Holdings are rebalanced to the base weights once per year in November.

On the crude oil front there are three choices – differing primarily in what futures contract(s) they hold and how they roll expiring futures positions forward.

US Oil Fund (USO) owns near futures month and rolls positions over a 4-day period.

US 12 Month Oil Fund (USL) spreads ownership across 12 months, rolls expiring month to the back.

DB Oil Fund (DBO) holds positions in a single month (currently June); between the 2nd and 6th trading days in contract expiration month the fund rolls position to one of 13 forward months depending on spreads and the application of DBs roll optimization methodology. This same roll methodology is applied to futures positions in other DB commodity ETFs.

 USO might be preferred in price-strengthening environments as inter-month futures spreads tend to become increasingly backwardated (i.e., forward months trading at discounts to near months). USL or DBO might be preferred in flat-to-weakening price environments in the event that forward futures prices move to premiums over nearby months.

Others (all hold near-month futures positions)

US Gasoline Fund (UGA)

US Heating Oil Fund (UHN)

US Natural Gas Fund (UNG)

All of the abovementioned ETFs have actively-traded options available.

There are also 2x leveraged long (UCO) and 2x leveraged short oil (SCO) ETFs (issued by Proshares). These generally don’t hold futures positions directly, although their prospectuses allow this in addition to the holding of options on futures. Most positions held by leveraged and inverse ETFs are in the form of over-the-counter swaps, with third party institutional providers / market-makers, which are trued up (collateral-wise) on an ongoing basis. There are critically-important tax considerations as well as serious cumulative return dynamics that investors need to fully understand before wading into any leveraged or inverse products.

Commodity exposure can also be taken on via exchange-traded notes (ETNs) – except for options, which are not available on ETNs. Multi-commodity ETNs tend to provide exposure to broad commodity indexes having a composition mix that is variable over time. Multi-commodity ETFs typically have a base allocation schedule across commodities that is rebalanced periodically. There are a number of very important differences between ETNs and ETFs, including important aspect of ETNs being debt instruments.

We outlined the critical features both ETNs and leveraged and inverse ETFs in feature segments in our May newsletter. Please let us know if you haven’t received a copy of that letter but would like to.

For those interested in equities exposure, there is an abundance of ETF alternatives holding stocks of companies engaged in energy sector, sub-sector and industry-level activities. And many of these also are available in un-leveraged, leveraged and inverse forms.

 We’ll follow up with discussion on metals, agricultural commodities and currencies – all worthy of attention.

Another Fan of Commodities

In the May 18, 2009 edition of Barron’s, there is an article from the authors of the book Globality: Competing with Everyone from Everywhere for Everything, that presents a concise explanation of why every long-term investor should have exposure to commodities in their portfolio.

While we are mired in an economic slump unlike anything since the great depression, it is important to know that in other parts of the world economies are still growing.  China, for example, still grew its GDP over 6% in the fourth quarter of 2008 and is expected to still have an expansion of its GDP this year.

There are a few important differences between the US and other economies that are still expanding.  The most significant is that those countries aren’t in hock up to their eyeballs and can invest in their economies without borrowing.  The second is the continuation of a dramatic growth in their middle class.  Millions of people are moving out of poverty each year in those countries.  When they do, they want to live like other middle class people around the world.  In short, they want more stuff, including more protein in their diet and new cars outside their new houses.

The growth in these populations, along with the growth in their economies generally, will put dramatic strains on the world’s natural resources.  Growth in a desire for protein rich diets will strain the food supply and agricultural inputs of all types.  The need to build infrastructure to handle enormous growth in autos and trucks will drive up demand for iron ore, and there will be the obvious strain on global oil supplies (do you think wind or solar power will be powering cars around the world anytime soon?).

For a US investor, the supply and demand economics of commodities make for a compelling investment theme.  These economics will be further augmented by the likelihood of a decline in the purchasing power of the dollar.  The massive growth of the money supply and the related massive deficits are likely to trigger a drop in the dollar that will add icing on the cake to the returns of long-term investors with exposure to commodities. 

Unfortunately, the majority of individual investors don’t have investments in these ‘hard assets’.   Right now is a good opportunity to allocate part of your portfolio to commodities.  An opportunity that will quickly vanish once inflation raises its ugly head over the next few years and the growth in economies around the world begins to accelerate.

ishares Putting Money in Your Pocket

The announcement hasn’t received a lot of attention, but if you participate in a 401k plan, there was a recent news release from ishares that might help put money in your pocket.

To date, the penetration of ETF’s into corporate 401k accounts has been minimal at best.  ETFs offer 401k participants dramatically lower investment costs over most 401k options, and they also offer broad exposure to investments rarely found in those plans: commodities and other alternative assets.  However, the back office infrastructure (think recordkeeping and trading platforms) of the industry was built primarily for traditional mutual funds and it has been difficult to convince industry players to change the way they do business for investment options that were, until recent years, not in high demand.

How times have changed.

Enlightened HR and Finance executives who oversee 401ks are now pushing for ETFs and ishares is stepping up to meet the demand.

ishares will team up with some of the largest administrators, custodians, and technology providers to make it very easy for financial advisors to provide ETFs investment options inside the plans.  ETFs can be offered as exclusive options or alongside traditional mutual funds.

It is too early to tell whether the ishares initiative will be successful, but the bet here is that ETFs are getting ready to make a big move against mutual funds inside 401k plans – and put a lot of money in investors’ pockets.

ETFs Eating Fidelity’s Lunch

“ETFs are beginning to eat everyone’s lunch in this industry.”

The above quote refers to the mutual fund industry and comes from none other than Jim Lowell, the editor of the Fidelity Investor newsletter.  A recent Bloomberg article highlighted a number of reasons for deteriorating asset levels at Fidelity, the largest mutual fund company in the world, and Lowell points directly to Fidelity’s lack of penetration into the growing ETF space as a primary cause.

Fidelity has watched its assets fall 4.9% over the past decade while the company’s total market share, including ETFs, decreased from 14.4% to 9.9%.  Poor fund performance (only 32% of the company’s funds beat peer funds in 2008) and the lack of a flagship fund to draw in new investors (no Fidelity fund ranks in the top ten in terms of assets) were clearly factors, but it’s apparent that the company’s failure to capitalize on the massive asset flows into ETFs was also a key culprit.

Comparatively, companies like Barclays Plc, State Street Corp, and Vanguard, the top three in exchange-traded fund assets, have continued to gain overall market share.  Consider Vanguard, the second largest mutual fund company, which saw their assets climb 91% over the same time period.  This comes as no surprise considering Vanguard’s concerted effort to become a major ETF player.  According to the Bloomberg article, Fidelity has only $65 million in ETF assets compared to Vanguard’s $40 billion (where a meaningful chunk of the company’s overall asset growth has originated).

In his latest newsletter, Lowell strongly recommended that Fidelity bid for iShares, the Barclay’s ETF business unit which they recently agreed to sell to CVC Capital Partners Ltd for $4.4 billion, in an attempt to stop the bleeding of assets and make an important strategic play in an industry increasingly gravitating towards ETFs.  This would have been a prime opportunity for Fidelity to immediately catapult to the top of the ETF industry and leverage their significant distribution and marketing muscle in a blossoming asset market.  Instead, Fidelity faces an uphill climb as they attempt to develop a viable ETF strategy to avoid getting their lunch eaten by the competition.  They had better move quickly.

Separating the Cart (instrument) from the Horse (strategy): The Real Beauty of ETFs

The educational starting point for all investors new to ETFs, be they novice or experienced professional, ought to be Investment Cart & Horse 101.

 ETFs enable investors to clearly and objectively distinguish, both in investment thinking and in investment practice, between the proverbial “cart” and “horse“, i.e., the investment instrument and investment strategy.

The gross mismatch between an active fund manager’s stated investment objective(s), and the broad (prospectus-imparted) license to roam widely and at will across much of the investment landscape, renders separation of investment instrument from investment strategy absolutely and utterly impossible to discern within the actively-managed mutual fund.

 For investors and advisors, unfortunately, any attempt to use actively-managed mutual funds to construct a disciplined and coherent strategy – one which demands control and predictability regarding the composition of portfolio holdings – is inescapably and entirely rendered an exercise in futility. “Asset allocation” strategies, at best, devolve to an extremely crude approximation game as individual fund managers exercise broad discretion in modifying, at times quite dramatically, security and asset class composition within their funds. Gone, usurped by active mutual fund managers, is investor or advisor control over the composition and modification of their strategy.

 In contrast, index-based ETF instruments provide a systematic, rules-based recipe for gaining exposure to a broad market or segment of a market. And while mutual fund reported holdings data ranges from three to five months stale, daily reporting of ETF holdings enables the investor or advisor to see precisely how index rules are reflected in a related ETF’s holdings. For the investor or advisor familiar with the index and the ETF, there are no surprises regarding the composition of an ETF. The manner of asset class coverage and security selection are “programmed” into the index and corresponding ETF.

Utilization of index-based ETFs enables the investor and advisor to shed active-manager decision-making risks – a step that is supported by a mountain of academic research and decades of market experience. With index-based ETFs, investor and advisor attention can be focused where it should be: entirely on strategy, understanding that the instruments will deliver intended exposures predictably and reliably. Actively-managed mutual funds rob investors of this capability by undermining the strategy, through manager drift, and weakening investor confidence and resolve to stick with a game plan. Active fund mangers, after all, have no definitive requirement or proclivity to do so themselves.

 In using ETFs, investors and advisors are better equipped to construct and deploy strategies as well as to consider the performance of instruments and strategies independently, largely as a result of their ability to “separate the cart from the horse.” These risk management and control perspectives can never be shared or enjoyed by investors and advisors using actively-managed mutual funds.