Risks of Futures Based Commodity Funds

Future based commodities ETFs, such as the United States Oil Fund, L.P. (USO on NYSE) have taken off in popularity around the world. These can be attractive investments for a variety of individuals and institutions, however, they are not without risk.

Perhaps first it’s best to differentiate between a futures based and an equities based fund. A futures based fund buys commodities futures, a type of derivative contract. An equities based fund buys equity securities in companies related to the commodity that you attempting to invest in. A futures based oil commodity fund may invest in NYMEX Crude Futures, whereas an equities fund will invest in oil companies such as Exxon Mobile.

The biggest risk of future based funds is certainly that the underlying commodity will decrease in value. For an oil commodity fund, if the value of oil goes down, the futures price goes down and your investment goes down.

But there is another risk that is often misunderstood or not even considered. That risk is roll-yield risk. Futures contracts have expiry dates, where the firm holding the contract must take delivery of the underlying commodity (in the case of a bullish fund). Since your oil fund doesn’t want millions of barrels of oil in their Manhattan office, they sell their futures shortly before the expiry date. Then they need to purchase the next month’s future contract in order to maintain their interest in oil.

The issue here is that the majority of commodities markets are currently in “Contango.” This means that the next month’s future price is higher than the current month’s price. As these funds sell oil at say, $75, and buy the next month at $80, they take a loss of $5 per contract. Or about 7% of fund value. Now the differences are not usually that great between months, but it illustrates the point.

Additional leverage is also sometimes applied in futures based funds. This is where the fund manager uses leverage or margin to buy more futures than what they could buy with the cash they have. Often, these funds will buy twice as many contracts as they could do using only cash. This doubles your risk and reward. If the commodity goes up, you will earn two times the increase. If the commodity goes down, you will lose twice as much as the decline.

The alternative to future based commodity funds is equity based commodity funds. These are not without risk either. While a pool of equities will generally perform in line with the rise or fall in the underlying commodity, sometimes temporary differences occur. This can be due to bad (or good) news about a firm, currency differences if equities are held cross-border and a number of other factors. This means if you are holding a fund during a day trade, you may be left with performance that does not correlate well with the underlying commodity.

Equity based funds can be leveraged as well, though this is more rare.

From the above information, one can see that futures funds can be used to for very short, day trading type activities and equity funds can be held over the long term. Using funds in this way will get you your desired exposure without unwanted risks!

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