Another ETF Eye-opener

Billions of dollars are pouring into exchange-traded funds (ETFs), but it seems there is still much for investors to learn about how these funds work.

We’ve written in the past about ETF liquidity issues that hurt investors during the May 6 “flash crash,” the trading costs that can drain away real returns for investors and the impact on investors when ETFs trade at a premium or a discount to their underlying net asset value.

This week’s cover story in Bloomberg Businessweek presents another eye-opener about ETFs. The story urges readers to steer clear of commodity ETFs, calling them “America’s worst investment.”

That could be something of an overstatement, but the article does bring up good points about the risks of investing in ETFs that invest in commodity futures.

One of these risks is “contango,” which is when the future delivery contracts for a particular commodity cost more than the near-term contracts. The ETFs don’t want to take physical delivery of commodities, so they sell their futures contracts before they expire and use the proceeds to buy more futures with more distant expiration dates.

Businessweek cites a contango example for crude oil futures affecting ETFs – in May, they sold June contracts with an average price of about $76 per barrel and bought July contracts with an average price of about $80 per barrel. The upshot is that the ETFs had to pay $4 per barrel more to replace the same merchandise – this represents an immediate loss to investors.

The crude oil market is still in contango: at midday today, the near-month September contract was $78, the October contract was $78.45 and the November contract was priced at $79.14. If contango is maintained, the ETFs that buy and sell crude oil futures are likely looking at more losses ahead.

Businessweek also points out professional traders know this weakness of these commodity ETFs and make a lot of money exploiting it.

ETFs can have a place in many investment strategies, but they are still not well understood by investors and that’s a big risk. Before buying, investors need to know what they are getting into so they can make the best decisions consistent with their investment goals.

About Frank Holmes 264 Articles

Affiliation: U.S. Global Investors

Frank Holmes is CEO and chief investment officer of U.S. Global Investors, Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure.

The company’s funds have earned more than two dozen Lipper Fund Awards and certificates since 2000. The Global Resources Fund (PSPFX) was Lipper’s top-performing global natural resources fund in 2010. In 2009, the World Precious Minerals Fund (UNWPX) was Lipper’s top-performing gold fund, the second time in four years for that achievement. In addition, both funds received 2007 and 2008 Lipper Fund Awards as the best overall funds in their respective categories.

Mr. Holmes was 2006 mining fund manager of the year for Mining Journal, a leading publication for the global resources industry, and he is co-author of “The Goldwatcher: Demystifying Gold Investing.”

He is also an advisor to the International Crisis Group, which works to resolve global conflict, and the William J. Clinton Foundation on sustainable development in nations with resource-based economies.

Mr. Holmes is a much-sought-after conference speaker and a regular commentator on financial television. He has been profiled by Fortune, Barron’s, The Financial Times and other publications.

Visit: U.S. Global Investors

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