What's Wrong With ETFs

Written by Matthew Hougan

Monday, 15 June 2009 10:45 | Related ETFs: USO

The crescendo of concern surrounding ETFs continues to grow, and something must be done. It’s rare that I open my email box these days and don’t find some rant from an investor about how they’ve been ripped off by this or that ETF. Usually, it involves one of the leveraged or inverse ETFs, which failed to provide the long-term returns the investor expected. I usually point readers to our recent webinar on leveraged and inverse ETFs, and explain briefly how compounding works. I remind them that these products are by and large working as designed, and gently suggest that it is the investor’s responsibility to understand how the products work before buying them. More recently, I’ve been getting an earful about commodity ETFs, particularly USO, the United States Oil Fund (NYSE Arca: USO). The concerns stem from a simple fact: While spot crude rose 49% year-to-date through June 1, USO was up just 13%. That 36% disconnect has a lot of people upset. For these readers, I walk through the basics of contango and backwardation, and explain that crude oil futures are a different animal from spot crude. I point to a few basic primers on the difference between spot prices and futures prices, such as this one from HardAssetsInvestor.com. Still, many of the readers think something nefarious is going on. Consider this post from “arizona" on our discussion boards: “I bought both USO and USL near their lows and I'm quite frustrated at what sure seems like these products are not even close to mimicking the performance of the spot price of oil which, as of this morning, sits above $71/barrel. I understand that these products track the price of futures and I've heard the whole contango story but it's my understanding that contango has unwound and these products are closer to their true price and are actually closer to backwardation now. Is this accurate? I'd love to see a chart which overlays the spot price, the futures price and the prices of both USO and USL” Well arizona, here you go. I’ve only used USO and not USL so that we could have the longest possible data range, going back to August 2006. The red line is USO. The green line represents the S&P GSCI Crude Oil Total Return Index, a simple rolling position in crude oil futures. The blue line is spot oil. A glance at the chart will tell you everything you need to know. USO has tracked its benchmark very well, but has lagged crude oil dramatically. That’s particularly the case since December 2008, when a massive contango opened up in the oil markets and caused a huge deviation between USO and spot crude. As for the second part of arizona’s question, yes, contango has largely disappeared from the market since this spring. And true to form, USO has come closer to tracking spot oil. From April 1 to June 1, USO traded up 31%; over the same time period, crude oil rose 30.4%. The problem is that if you bought in way back in December, those early losses are still haunting you. Morningstar recently issued a statement calling for ETFs like USO and leveraged/inverse products to be regulated as derivatives. It said that individual investors who buy these products should be treated like investors who purchase options. Before you can buy or sell options from a brokerage account, you must agree that you’ve read a lengthy paper on how options work. Similarly, Morningstar called for a revamping of the educational and licensing requirements of financial advisers to include coverage of these unique ETFs and how they work. Too many advisers are using these as a “backdoor” to get leveraged, short and commodity exposure into client accounts, it said, and those advisers should have to demonstrate expertise before they buy and sell. I think I agree. ETFs are tremendously empowering because they deliver institutional-caliber exposure to all investors. But clearly, not all investors understand these products well enough to use them properly. Investors are having sour experiences and losing money. It’s making them question the value of even true-vanilla ETFs. Education and revamped licensing agreements could be a first step toward correcting this. Later this week, industry legend John Bogle will be making a presentation to the Journal of Indexes editorial board where he will, among other things, discuss some of the problems with ETFs. Prior to the presentation, IndexUniverse.com will be hosting a free dial-in webinar with Mr. Bogle (register here) where investors can call in and ask Mr. Bogle any question they want. I won’t be in New York for the actual board meeting, but I will be dialing into the webinar, and the questions I want to ask are these: Do we need to regulate leveraged, inverse and commodity ETFs? Have ETFs opened up too much of the market for investors? Here’s the thing: I’ve been doing this for two years now, and still the emails pour in. All the information people need is out there, but still the rants occur. The problem is that the wave of new investors pouring into ETFs is growing every day. Working in this industry, it sometimes feels like ETFs are the center of the investing universe. After all, they are one of the fastest-growing financial products in the world, and they increasingly dominate trading volume on the national exchanges. But the truth is that most investors are still unaware of ETFs. We’re probably in the third or fourth inning in terms of investor pickup. A lot of new investors are coming to the space every day, and they’re making the same old mistakes that other people made in these leveraged and inverse ETFs.