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 commodity ETFs were such a terrible investment vehicle for individual investors. Since Bloomberg is pretty reputable, and since I had previously invested (and lost money) in RJI, a commodity ETN (exchange-traded note) that tracks the Rogers International Commodity Index, of Jim Rogers fame, I was really interested in what the article had to say.
As I’ve posted here before, I’ve relied on ETFs 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 “contango“, something I had never heard of. It boils down in essence to the nature of a futures contract. Unlike an option, 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 double inverse funds and others with complicated-sounding names.
At one point, a very reputable friend suggested we purchase TBT 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.]