What to beware of when trading commodity ETFs

Recent action in the commodity markets begs the question of how to play the game and stay in it. 

Until about a decade ago, the only way to get direct exposure to this market was via futures contracts. Now, while ETFs provide access, expect at least some degree of “drift” between the way the ETF and its underlying commodity contracts move. 

ETFs designed to track futures contracts have a huge fundamental disadvantage compared to ETFs based on a basket of equities.

Equity-based ETFs such as the Financial Select Sector SPDR Fund (XLF, quote) use various bank stocks to replicate movement in their target sector, theme or segment of the market.

However, commodity ETFs must build a complex portfolio of futures contracts and over-the-counter swaps to attempt to “reflect” price movement in the underlying commodity.

Last week’s crude oil and natural gas headlines may generate great appetite for commodity ETFs for those with no other way to engage in the futures market, but ultimately when it comes down to it there is no good way to represent commodities like crude oil, natural gas, gold and grains in ETFs that are traded like stocks.

Some of these ETFs fare better than others when it comes to tracking the underlying commodity. ETFs that hold physical assets such as the SPDR Gold Shares Trust (GLD, quote) tend to track their targets better than those that never take delivery like the United States Natural Gas Fund (UNG, quote). 

UNG suffers from a further problem compared to other commodity ETFs. Natural gas has been dropping for nearly four years now, causing an ever-increasing skew to the price curve called a contango. The continued price drop has made the skew more and more extreme.

To understand the problem traders need to realize futures contracts are monthly instruments similar to stock options. Futures contracts have a shelf life or expiration date, after which they must roll over to the next active month. 

This forces UNG fund managers — along with those running every other commodity-based ETF–  to extend their exposure every 30 days to the next monthly contract. This process is known as “forward roll.”

Since natural gas in contango is causing a skew in the price curve and UNG fund managers are forced to roll forward their front contract every 30 days, they end up paying an expensive premium to roll the contracts each month. This causes an intrinsic drop in value every month.

Commodity ETFs have another disadvantage — and they share this one with their counterparts on the equity side.

Although ETFs are traded like stocks, they are also a managed entity not unlike a mutual fund. Every ETF has group of people managing the fund(s), buying and selling the underlying assets. This is not done for free unfortunately, and such each ETF has a set of management fees similar to what mutual funds and 401(k)s charge. These fees vary from fund to fund and are required to be disclosed in the prospectus.

Bottom Line: Commodity ETFs have a lot stacked against them for traders hoping to use the vehicles as medium- to long-term investments. Knowing the structure of the commodity ETFs, traders can use them as short-term trading vehicles; in fact many of the ultra-short and double-long index ETFs are used by day traders to anchor a quick directional trade.

To trade commodities seriously one may want to look at the commodities market directly, especially with many online brokers today allowing access to the electronic trading of the futures exchanges at very low commissions.

Later we’ll look into how the FOREX market can be used to benefit in the rise and fall of commodity prices.