ETF Edge-In oil surge, new ETFs lag the real thing

BOSTON Wed Feb 23, 2011 4:45pm EST

BOSTON Feb 23 (Reuters) - With stocks falling and oil surging on Mideast turmoil, getting into an ETF based on crude prices might seem a great way to invest in a few barrels.

But the way new ETFs are trading it's more like getting half barrels with a lot of suds on top.

It's one of the pitfalls of exchange traded funds that they often do not do what investors think they will.

While ETFs have added to the wide array of choices for investors, not all are created equal. And there may be better ways to benefit from oil's rise by picking other energy-related investments.

The problem for ETFs is matching the funds to the value of the underlying assets. That is especially difficult when they are based on commodity futures -- and even more so when there are sudden market moves, as happened in recent weeks with oil.

DISAPPOINTING START

ETF managers' efforts to match barrels to fund shares have proved disappointing in the past. But a new round of ETFs designed to track oil markets more closely has fallen even further behind the mark.

Neither of the two "second generation" funds is keeping up with the latest oil surge. The current month U.S. light crude futures contract CLc1 on the NYMEX has jumped from its 2011 closing low of $84.32 on February 15 to $99.77 on Wednesday, an 18.3 percent increase.

But the new $550 million PowerShares DB Oil Fund (DBO.P) has risen only 8.7 percent and the $236 million United States 12 Month Oil Fund (USL.P) is up 7.8 percent.

The two funds were supposed to avoid the lagging performance of older ETFs like the United States Oil Fund (USO.P). This time around, the older fund has done best, rising 13.9 percent.

SIMPLE MATH, DIFFICULT TRADING

The math might seem simple enough. Oil jumped as the Libyan uprising trimmed about 1 million barrels per day of crude oil output, estimated Barclays analyst Amrita Sen in a research note.

Fears of contagion have added still more. Should the unrest bring production to a halt in neighboring Algeria as well, Nomura analysts said oil prices could peak at $220 a barrel. [ID:nLDE71M1P5]

But contagion does not tell the story for why the ETFS lag. It is the less sinister problem known as contango. That is the description of a futures markets when prices for later months rise above those of the present month. And it also creates a substantial drag on ETFs rolling over contracts on which the funds are based.

The chance of rising oil prices has put oil futures into a sharp contango in recent weeks.

Older funds like US Oil invest only in the most current month of the NYMEX's main oil contract. That means they have to roll over all their holdings when the contracts expire on a predictable schedule. And that has allowed other traders to game the system, pushing up the price of the contracts just as the funds have to buy.

To avoid this problem, the 12 Month fund splits its holdings among an entire year's worth of different futures contracts. The Powershares fund uses its own index that invests in various months of futures based on a formula that is supposed to minimize contango problems.

LOOK CLOSELY

Every fund has its own formula for tracking commodity prices. Analysts and fund sponsors say investors need to understand exactly what they are buying.

John Hyland, chief investment officer at US Commodity Funds, sponsor of the US 12 Month fund, said some investors may not understand that ETFs cannot exactly match the performance of the "current month" oil futures contract.

Returns for the "current month" ignore the costs of rolling over contracts at each month's actual expiration. "It's a creative fiction," he said.

The Powershares DB fund is designed to capture moves in oil over longer periods for traditional "buy and hold" investors, not raid-fire traders, Martin Kremenstein, chief investment officer for the fund platform, said.

"For a long-term allocation, this is the most efficient way to stay invested in oil," he said. The fund has gained 26.5 percent since it was introduced in January, 2007, far outperforming ETFs that stick to the current month's contract like the original US Oil Fund.

Starting on Wednesday, investors have yet a third option for oil ETFs. Teucrium Trading, which already manages corn and natural gas futures funds, is opening the Teucrium WTI Crude Oil Fund which will trade under the symbol CRUD.

The fund will hold oil futures from three different months spread over more than a year in an attempt to avoid contango problems and price squeezes at expiration. But in the short term it has not kept up with the market's upward move.

OTHER WAYS TO PARTICIPATE

For those who missed the oil price rise entirely, the smarter investing plays now are probably found elsewhere, say analysts and fund managers.

Michael Gayed, chief investment strategist at Pension Partners in New York, favors stocks of alternative energy producers and the Guggenheim Solar ETF (TAN.P). The fund's top holdings include First Solar (FSLR.O), Trina Solar (TSL.N) and Renewable Energy Corp ASA (REC.OL).

The share prices of oil producers have already run up dramatically, leaving alternative energy stocks far behind.

"While the energy sector has had a strong move since November, I'd rather buy something which has more potential to catch up," he said.

Guggenheim Solar is up only 7.7 percent over the past year versus a 50.8 percent jump in the iShares Dow Jones US Oil Equipment ETF (IEZ.P) and a 40.8 percent rise in the broader Energy Select Sector SPDR ETF (XLE.P).

"As the price of oil rises, alternative energy becomes more and more correlated and starts to look like a leveraged oil play," Gayed said. "With this big shock, there will be a huge amount of new money going into wind turbines, solar and other alternatives again."

The run-up in oil producers may be flashing a warning sign of a possible short-term setback as the crisis settles down, according to Justin Walters, co-head of research and investments at Bespoke Investment Group in Harrison, New York.

The energy sector's recent 40 percent gain has been matched only five other times since 1940. And four out of the five times, the move over the next month was down, Walters said.

"We're due for a pullback here," Walters said.

(Reporting by Aaron Pressman. Editing by Richard Satran)