A must-read: Bloomberg’s pitfalls and perils of investing in commodity ETFs

ETFs, Value investing

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While sitting in a doctor’s office the other day, I happened across an article in Bloomberg magazine entitled “America’s Worst Investment” (magazine cover shown here) that explained why . Since Bloomberg is pretty reputable, and since I had previously invested (and lost money) in , a commodity ETN (exchange-traded note) that tracks the Rogers International Commodity Index, of fame, I was really interested in what the article had to say.

As I’ve posted here before, I’ve quite a bit in the past to do the bulk of my passive, buy-and-hold investing. They’re an easy way to diversify and since most of them track indices, there’s not much to think about compared to the difficulties of evaluating an individual stock. After reading Jim Rogers’ books, I was interested in diversifying into commodities, and when someone finally came out with an ETN that reflected his index a couple of years ago, I bought in.

The Bloomberg article is quite eye-opening and explains why commodities ETFs that are based in futures can be a no-win situation for individual investors. You’ll have to read the article to fully grasp the pitfalls of these vehicles, but one vocabulary word I learned was ““, something I had never heard of. It boils down in essence to the nature of a futures contract. Unlike an , where you have the right but not the obligation to buy or sell an underlying security, in futures contracts, you have the obligation to take delivery of the underlying security or good unless you rid yourself of that contract in some way.

And yes, this means that, for example, you’d be taking delivery of barrels of crude oil or pork bellies if you as a fund manager still own your part of the contract when the contract’s expiration date comes. Instead of taking delivery of these underlying products, these fund managers would instead buy contracts for the next month at a higher price in order to avoid physically taking delivery of those products, and these new contracts are always done at a set time. I’m probably glossing and over-simplifying here…hence the reason you should read the Bloomberg article for yourself, especially as it covers some other pitfalls that the individual investor is subject to by fund managers. It turns out that many people who got burned in buying commodities ETFs also had no idea what was happening until they took a lot of time to educate themselves.

The lesson I learned (and not a new one, sadly) is that I should have better educated myself on commodities ETNs like RJI before investing. If I can’t understand what I’m buying, I should just stay away. Separately, I’ve noticed that ETFs have taken an exotic turn in recent years. Now there are things like and others with complicated-sounding names.

At one point, a very reputable friend suggested we purchase last year as a hedge against inflation. I ended up not purchasing that simply because I found myself having to do a lot of thinking before I could figure out whether the price of the fund should go up or down with interest rates: “Let’s see…if the Fed raises interest rates, that makes bond prices go down, which makes TBT go up twice the amount that the bond price index underneath it went down on a daily basis”…it just wasn’t intuitive enough. Guess I’m just a simpleton and prefer less complexity when it comes to investing my money.

[Updated on September 28, 2010: This post originally referred to RJI as an ETF, which a reader below correctly identified as an ETN (exchange-traded note). I’ve fixed this in the blog post above but didn’t show strikethroughs for readability. My response to the comment is also provided below.]

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3 Feedbacks on "A must-read: Bloomberg’s pitfalls and perils of investing in commodity ETFs"

Leslie

Gladys – thanks for your comment and correction. You’re absolutely right — RJI is an ETN and not an ETF. I’ve made corrections to this and left a note on the updated post.

To clarify, I didn’t mean to blame Jim Rogers at all but my own lack of education…I believe this came across in the post. I still follow him and enjoy his writings, and obviously his prowess as an investor has already been proven :) And I agree that investment results always have a timing element to it, even if you buy-and-hold.

As quoted from RJI’s prospectus, the underlying index of the ETN is still based on futures contracts:

“The Index represents the value of a basket of futures contracts on commodities consumed in the global economy, ranging from agricultural toenergy and metals products.”

I guess I still fail to really understand that if an underlying asset of an ETN is still based on commodities futures why the dangers of investing in these as ETFs go away. If you can explain or point me to any links or articles that clarify this point, I’d really appreciate it!



Bruno

As Leslie points out from the RJI prospectus, this ETN is based on an index comprised of commodity futures. Page PS-11 in the prospectus pricing supplement specifically discusses positive roll yield for commodities trading in backwardation, and negative roll yield for commodities trading contango.

It seems clear to me that the index is based on front-month future contracts which roll and experience roll yield. Since, the ETN is based on the index, it too will experience the same roll yield.

That’s not to say it’s a bad or good investment. It just means you can’t focus solely on the spot prices. Recognize that contango situations will present negative roll yield.

I found the Bloomberg article interesting from a number of standpoints. I can’t believe that neither the Merrill nor Schwab reps knew what “contango” was. A simple Google search of the word will show hundreds of hits on sites that clearly define contango, backwardation, and roll yield. I’m also continually amazed at the number of people who invest in products without ever reading the prospectus (at least the risk section) or ignore elements they don’t understand.

Regarding commodity ETFs, some take possession of the physical commodity (at least where it’s physically practical). Some invest in a spread of future contracts, rather than just the front month, to minimize some of the trading anomalies. As always, know where your money is going.



Leslie

@Bruno, thanks for your comments. Again, you’re right, I’m as guilty as anyone of investing in something I didn’t understand. I naively approached investing in RJI by thinking of it as “any other” ETN/ETF (which I know now not to be the case) — that is, I just assumed it was an easy way to diversify into a different type of asset through an vehicle that passively tracked an index. I didn’t know what “contango” was until I read the Bloomberg article. At any rate, lesson learned.

Although I use Schwab as my online broker, I don’t doubt that their reps and agents have never heard of “contango”. The next time my official branch contact calls offering his services, I think I’ll ask him just to have an informal data point. Maybe if he can explain it to me, particularly related to an ETN like RJI, I’ll take him up on his offer.



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