Suddenly everybody was a speculator.
And some were losing big. The commodity ETFs weren't living
up to their hype, and the reason had to do with a word Wolf had
never heard before. As he browsed the blogs, he says, "I'm
seeing people talking about something called contango. Nobody
would define it." Wolf called his broker and asked about
contango... Contango eats a fund's seed
corn, chewing away its value.
+------------------------------------------------------------------------------+
ETFs Imperil Investors When Contango Conspires With Pre-Rolling
2010-07-22 05:00:25.262 GMT
Peter Robison, Asjylyn Loder and Alan Bjerga
July 22 (Bloomberg) -- Like so many investors in the spring
of 2009, Gordon Wolf needed to dig out of a hole.
A 68-year-old psychologist in Napa, California, Wolf was a
buy-and-hold sort of guy, yet the nest egg he had entrusted to
his broker at Merrill Lynch was suddenly down by more than 50
percent.
The broker had invested much of it in a range of exchange-
traded funds, or ETFs, a relatively new financial innovation
that was replacing mutual funds in the hearts and portfolios of
many investors. An ETF, which can be bought or sold like a
stock, attempts to track the price of a particular basket of
assets--tech stocks, for instance, or high-yield bonds, or
commodities ranging from wheat to gold to oil to natural gas.
The commodity ETFs were supposed to offer a hedge against
equity losses, but in the crash of 2008 everything fell in
tandem. Now it was early 2009, and Wolf was watching oil fall to
$34 a barrel. That had to be an opportunity, he figured, so he
called his Merrill broker and asked about the U.S. Oil Fund, an
ETF designed to track the price of light, sweet crude. "This
seems to be something good," Wolf told the broker, and had him
buy about $10,000 of USO.
What happened next didn't make sense. Wolf watched oil go
up as predicted, yet USO kept going down. In February 2009, for
example, crude rose 7.4 percent while USO fell 7.4 percent. What
was going on? Wolf logged on to Seeking Alpha, a financial blog,
and searched for USO. He found plenty of angry discussion about
the fund -- lots of people were losing lots of money, because
thousands of American investors had seen the same sort of
opportunity Wolf had.
Record Investments
By the end of 2009, they had a record $277 billion invested
in commodity ETFs and other securities linked to raw materials
-- a 50-fold jump from $5.5 billion a decade earlier, according
to Barclays Capital. During that time, Wall Street had
transformed the reputation of commodities from a hyper-volatile
investment that can steal your shirt to a booster for battered
portfolios, something that rose when stocks fell and hedged
against inflation, Bloomberg Businessweek reports in its July 26
issue. People who would never think of buying a tanker of crude
or a silo of wheat could now put both commodities in their
401(k)s. Suddenly everybody was a speculator.
And some were losing big. The commodity ETFs weren't living
up to their hype, and the reason had to do with a word Wolf had
never heard before. As he browsed the blogs, he says, "I'm
seeing people talking about something called contango. Nobody
would define it." Wolf called his broker and asked about
contango.
'Rigged Game'
"I don't know what it is," he replied. He called his
other broker, at Charles Schwab. "He didn't know either," Wolf
says. "He said he'd ask around." Weeks later, after Wolf
educated himself, he fired his Merrill broker and pulled out his
money. (Merrill and Schwab declined to comment.) By then he had
lost $2,500 on USO. "If it wasn't a rigged game," he says, "I
could figure it out. But it is a rigged game."
Contango is a word traders use to describe a specific
market condition, when contracts for future delivery of a
commodity are more expensive than near-term contracts for the
same stuff. It is common in commodity markets, though as Wolf
and other investors learned, it can spell doom for commodity
ETFs.
When the futures contracts that commodity funds own are
about to expire, fund managers have to sell them and buy new
ones; otherwise they would have to take delivery of billions of
dollars' worth of raw materials. When they buy the more
expensive contracts -- more expensive thanks to contango -- they
lose money for their investors. Contango eats a fund's seed
corn, chewing away its value.
Futures Roll
Here's an example. The Standard & Poor's Goldman Sachs
Commodity Index (S&P GSCI), which tracks 24 raw materials, is
the basis for as much as $80 billion of investment. Managers of
funds linked to the index, created by Goldman in 1991, have to
buy their next-month futures contracts between the fifth and the
ninth business day of each month.
During that period in May, fund managers sold contracts for
June delivery of crude oil priced at $75.67 a barrel, on
average, according to data compiled by Bloomberg. Managers
replacing those futures with July contracts had to pay $79.68.
After the roll period ended, the July contract fell back to
$75.43. For each of the thousands of contracts, in other words,
managers paid $4 for nothing -- and the value of their funds
dropped accordingly.
Dumb Money
Contango isn't the only reason commodity ETFs make lousy
buy-and-hold investments. Professional futures traders exploit
the ETFs' monthly rolls to make easy profits at the little guy's
expense. Unlike ETF managers, the professionals don't trade at
set times. They can buy the next month ahead of the big
programmed rolls to drive up the price, or sell before the ETF,
pushing down the price investors get paid for expiring futures.
The strategy is called pre-rolling.
"I make a living off the dumb money," says Emil van
Essen, founder of an eponymous commodity trading company in
Chicago. Van Essen developed software that predicts and profits
from pre-rolling. "These index funds get eaten alive by people
like me," he says.
A look at 10 well-known funds based on commodity futures
found that, since inception, all 10 have trailed the performance
of their underlying raw materials, according to Bloomberg data.
The biggest oil ETF, the U.S. Oil Fund, which Wolf bought and
which now has $1.9 billion invested in it, has dropped 50
percent since it started in April 2006 -- even as crude oil
climbed 11 percent.
Gas Fund
The $2.7 billion U.S. Natural Gas Fund, offered by the same
company, has plummeted 85 percent since its launch in April 2007
-- more than double the 40 percent decline in natural gas.
Deutsche Bank's PowerShares DB Agriculture Fund has eked out a 3
percent total return since January 2007, while the weighted
average of its commodity components has risen 19 percent.
To be sure, those spot prices -- reported on cable business
channels and other outlets -- set an unreachable benchmark. If
investors try to match the spot market using ETFs, they can get
killed by contango. If they dodge contango by buying physical
commodities instead, they must pay heavy storage costs that can
easily turn gains to losses.
The allure of commodity investment has hit even the most
sophisticated investors. The California Public Employees'
Retirement System, the largest public pension in the U.S., has
lost almost 15 percent of an $842 million investment in
commodity futures since 2007, according to its latest filings,
depriving it of income at a time when it has sought taxpayer
money to cover retiree benefits. It defends the investment as
insurance that will pay off in the event of inflation.
Money Transfer
Just as they did with subprime mortgage-backed securities,
Wall Street banks are transferring wealth from their clients to
their trading desks. "You walk into a casino, you expect to
lose money," says Greg Forero, former director of commodities
trading at UBS. "It's the same with these products. You're
playing a game with a very high rake, a very high house
advantage, and you're not the house."
Selling commodity investments has long required training in
the futures markets. Selling commodity ETFs doesn't, says
Michael Frankfurter, managing director of Cervino Capital
Management, a commodity trading adviser in Los Angeles.
Turning commodity futures into securities unleashed a much
larger sales force -- stockbrokers selling a product many of
them didn't understand, he says. Passive buy-and-hold investors
at one point in mid-2008 held the equivalent of three years of
production of soft red winter wheat. Wall Street's success in
attracting those buyers boosted demand for futures contracts,
which helped determine what consumers would pay for baked goods.
Bread and Chocolate
Wheat prices jumped 52 percent in early 2008, setting
records before plunging again, and sugar more than doubled last
year even as the economy slowed, forcing Reinwald's Bakery in
Huntington, New York, to fire five of its 32 employees. "You
try and budget to make money, but that's becoming impossible to
predict," says owner Richard Reinwald, chairman of the Retail
Bakers of America.
Cocoa futures reached a 30-year high early this year
because of speculators, according to Juergen Steinemann, chief
executive officer of the world's largest maker of bulk
chocolate, Zurich-based Barry Callebaut. At the airport, the new
$25 charge for checking a suitcase exists partly because
airlines have to set aside cash to hedge against sharper ups and
downs in oil prices, says Bob Fornaro, CEO of AirTran Holdings.
"This has been very, very good for Wall Street," he says.
No Guarantees
Sponsors of commodity ETFs and similar investments --
including Deutsche Bank AG, Barclays, and UBS -- warn of the
risks in their prospectuses. Those banks declined to comment,
but defenders say it's unfair to single out returns over any
specific time period. "Diversification doesn't mean you're
always going to be up, but you spread the risk differently,"
says Kevin Rich, a former Deutsche Bank executive who developed
the first futures-based commodity ETFs in the U.S.
Not every trader is comfortable with what Wall Street has
done. Forero, 36, became director of commodities trading at UBS
in 2007. A New Yorker whose father was Colombian consul to the
U.S., he began his career at JPMorgan Securities, then worked a
series of energy-trading jobs before landing at UBS's securities
division in Stamford, Connecticut, where the Swiss bank operates
one of the world's largest trading floors. UBS had bought
Enron's energy desk, so Forero sat among veterans of the
disgraced company.
UBS sold notes linked to futures and earned commissions
handling the monthly roll for clients such as USO, Forero says,
adding that he didn't do the roll himself. ("That was a
different group," he says.)
Subprime Sting
In January 2009, stung by subprime losses that forced a
Swiss government bailout, UBS shut its energy desk. Forero and
his wife had a newborn daughter and a $1.2 million Colonial in
Norwalk, Connecticut. With no job, Forero holed up in his home
office, sifting through data with a Hewlett-Packard scientific
calculator. He became convinced that the products he had sold
were hurting investors and disrupting supply and demand for
basic commodities.
"I've always been a little naïve, and maybe I still am,"
he says. "But how can the government allow that? People in our
industry talk about it--everybody knows about it. This has to
come to light."
Bob Greer spent long days during the mid-1970s in the
basement of a public library in Tulsa, going through rolls of
microfilm. He painstakingly copied commodity prices onto yellow
legal pads, then tallied them up on a handheld calculator --
piecing together the first investable commodities index. An
economist and mathematician with a Stanford University MBA,
Greer had worked at a commodities brokerage in Dallas, where he
got the idea that raw materials might belong in investment
portfolios, alongside stocks and bonds.
Basement Revelation
Greer's work in the library basement led to the 1978
publication of his first article on buy-and-hold commodity
investing in the Journal of Portfolio Management. "Conservative
Commodities: A Key Inflation Hedge" outlined the benefits of
passive, unleveraged, long-only bets on raw materials. The idea
didn't catch on, and Greer went into commercial real estate.
At the time, everyone knew someone who had gone broke
betting on soybeans, or a gold bug who hoarded coins against
catastrophe, he says. Commodity investing wasn't respectable.
"People did not believe that the words 'commodity' and
'investment' belonged in the same sentence," says Greer, now 63
and an executive vice-president at Pimco in Newport Beach,
California.
Goldman Launch
Greer had long since given up on his idea by 1991, when
Goldman launched its benchmark commodity index and began selling
swaps that tracked it to institutional investors. Two years
later, Daiwa Securities hired him to create an index based on
the one he had dreamed up in Tulsa. Commodities investing was
catching on, and Greer says a breakthrough came when the tech
bubble burst in 2000.
By 2002, when the Standard & Poor's 500-stock index plunged
25 percent, investors were desperate for alternatives. That
year, Pimco hired Greer to start its Commodity RealReturn
Strategy Fund. The actively managed fund has returned more than
200 percent since its debut.
While Greer was launching his fund, a natural resources
consultant in Australia, Graham Tuckwell, was developing the
first commodity ETFs. Tuckwell had worked for Salomon Brothers,
Credit Suisse First Boston, and Normandy Mining, Australia's
largest gold producer; by 2002 he was working with the
Australian Gold Council, looking for a way to encourage gold
investing.
'Funny Little Things'
An acquaintance mentioned an oddball product: wine
securities. They were "funny little things," Tuckwell says,
that allowed cases of a particular vintage to be traded on a
stock exchange. He decided his fund would work the same way.
Instead of cases of wine, the shares would be backed by gold
bars stored in a vault.
Tuckwell's innovation, rolled out in 2003 and then called
Gold Bullion Securities, soon became a hit, and in April 2004 a
contact at Royal Dutch approached him with a question: Could he
do for oil what he had done for gold? "An oil refinery takes an
enormous amount of working capital because you have all this
crude oil sitting there," Tuckwell says. He went to Shell and
suggested a product that would help the company make money from
the crude it keeps in storage.
Backing the oil ETF shares with the physical commodity
proved unwieldy. Gold was compact and easily stored in a vault;
oil was in depots, pipelines, and tankers all over the world.
Instead, Tuckwell's London firm, ETF Securities, entered into a
swap agreement with Shell.
Shell Deal
Tuckwell used investors' money to buy contracts from Shell,
and Shell gave them the same return as crude oil, based on the
price of Brent crude futures. Since the oil ETF started trading
in London in 2005, Brent has risen 30 percent; the fund has
dropped 27 percent. The risks are clearly outlined in the
prospectus, Tuckwell says, and anyone who doesn't understand the
product first shouldn't buy it.
Banks used new academic research to pitch commodities as a
safe way to diversify. In one 2004 presentation, Heather
Shemilt, then a managing director and now a partner at Goldman,
called the strategy "the portfolio enhancer." That same year
two professors, Gary B. Gorton of the Wharton School and K.
Geert Rouwen-horst of Yale University, published a paper, funded
in part by American International Group Inc., which argued that
an investment in a broad commodity index would have brought
about the same return as stocks from 1959 to 2004, and would
often rise when stocks fall.
Beneath the Chandeliers
Under the crystal chandeliers of San Francisco's Palace
Hotel in June 2005, Rouwenhorst presented his findings to more
than 100 investment pros; Shemilt also appeared, alongside
managers from Barclays and AIG. After the talk, many in the
audience had the same question: How do I do this?
Barclays, Goldman, AIG, and other firms had developed ways
to help them do it -- several types of investments based on
futures contracts, which had been used for almost 150 years to
arrange the price and delivery of a given commodity at a
specified place and date. These products remained the province
of wealthy investors. In 2004, however, Deutsche Bank's Rich
devised a commodity ETF that opened the door to retail investors
when it launched two years later.
There was an obstacle: The U.S. Commodity Futures Trading
Commission, a regulatory board created in 1974 after a runup in
grain prices, required buyers of certain commodity investments
to sign a statement saying they understood the risks. The banks
argued that it would be impossible to collect so many thousands
of signatures for a product designed to trade like a stock.
'Democratized Investing'
In 2005, Deutsche Bank lawyer Greg Collett, who had worked
at the CFTC from 1998 to 1999, helped persuade the commission to
waive the rule and let funds replace it with their prospectus.
That would provide adequate warning, the CFTC concluded. Collett
says he believed the fund "democratized" commodity investing.
Rich started attending National Grain & Feed Association
conferences to introduce ETF investors to the traditional
players, such as farmers and silo operators. One conference
featured a boat ride up the Illinois River to visit a grain
depot, giving Rich a chance to explain his new ETFs to old-
school grain traders. "They were a bit suspicious," he says.
These days, the Wall Street banks are more like those grain
traders than you might think. They have equipped themselves to
take delivery of raw materials when they choose to, so they can
wait for the commodity price to rise without having to roll
contracts, giving them another advantage over ETF investors.
Goldman owns a global network of aluminum warehouses.
Chartering Tankers
Morgan Stanley chartered more tankers than Chevron last
year, according to shipbroker Poten & Partners. And JPMorgan
Chase hired a supertanker to store heating oil off Malta last
year, likely earning returns of better than 50 percent in six
months, says oil economist Philip Verleger. "Many, many firms
did this," he adds, explaining that ETF investors created this
"profitable, risk-free arbitrage opportunity" when they plowed
into commodities. Futures are bilateral; if someone's buying,
someone else is selling. "And the only way to attract sellers
is to offer them a bigger profit," Verleger says. "So,
ironically, passive investors have been sowing the seeds of
their own defeat" -- and contributing to the contango that does
in their funds.
Even the former Deutsche Bank lawyer who helped open the
floodgates now says something has gone wrong. "Like most things
on Wall Street, they have been over-marketed," Collett says.
"The complications have been glossed over. I'm not sure the
people marketing them even understand the complications, and
that's a shame." Collett left Deutsche in 2008 and is pursuing
a career as a stand-up comic in New York.
Rugby Hooker
If you're going to serve as de facto spokesman for the
commodity ETF industry, it probably helps to have played college
rugby. John Hyland is the chief investment officer of U.S.
Commodities Funds, the Alameda, California, company that manages
USO and its sister fund, U.S. Natural Gas. Majoring in political
science at the University of California at Berkeley in the late
1970s, Hyland played the rugby position called hooker, which
requires toughness and fancy footwork to jerk the ball out of
the scrum. "My wife calls me the human battering ram," he
says. For the past year he's been trying to keep his funds out
of a regulatory pileup.
Fresh to Commodities
Hyland, 51, had never managed commodities before he joined
U.S. Commodity Funds LLC in 2005. He had been in the investment
business for 20 years -- running portfolios and mutual funds --
before he teamed up with U.S. Commodity CEO Nicholas Gerber. In
2006, as Gerber and Hyland were trying to win approval from the
Securities and Exchange Commission for the U.S. Oil Fund, the
fund's prospectus hit the desk of Dan McCabe, then CEO of Bear
Hunter Structured Products, which was to be the fund's first
specialist. McCabe recalls immediately spotting how traders
would pick USO apart.
"Anybody who looked at it prior knew exactly what would
happen," McCabe says. "From a trading side -- and I spent most
of my life trading -- I would say, 'Wow, what a great
opportunity.'"
After Hyland's oil and natural gas funds surged in 2008 and
2009, he found himself in the crosshairs of the CFTC, which was
holding hearings on energy speculation in the wake of $147-a-
barrel oil. CFTC Chairman Gary Gensler began calling for limits
on the number of energy contracts a single trader can hold. As
Hyland's ETFs became poster children for the problem, Hyland
became their most vocal advocate.
California Crude
At an ETF conference in Boca Raton, Florida, in January, he
showed up with bottles of Merlot stamped with the company logo
and the words "California Crude." The chances of pre-rolling
his funds, he maintains, are "historically a 50-50 crapshoot"
-- a view many traders reject. His funds track daily moves in
futures prices, he continues, because spot prices are impossible
to capture unless you store fuel yourself. "I don't think the
products are flawed," he says. "They do what they say they're
supposed to do."
On Feb. 6, 2009 -- to cite one example -- USO did what
McCabe guessed it might. It gave traders an opportunity to
profit at the expense of the fund's investors, McCabe says. With
oil prices near their lowest in more than four years, long-term
investors like Wolf had flocked to the fund; its monthly roll,
taking place that day, had grown so large that it represented
financial contracts for almost 78 million barrels of oil,
roughly four times the amount of oil the U.S. consumes in a
single day.
Widening Spread
On Feb. 6, the price spread between expiring crude oil
futures and those for the following month widened by $1.39 a
barrel, or 30 percent, to $5.98. The price jump was so extreme
that the CFTC announced an investigation within weeks, saying it
"takes seriously issues surrounding price movements in our
nation's vital energy markets."
In the midst of the price swing, according to an account
released by the CFTC in April, a Morgan Stanley trader made a
secret deal with a broker at UBS, acting on behalf of USO.
Around noon, Morgan Stanley agreed to buy 33,110 of the fund's
expiring March contracts and sell it April contracts, the CFTC
said. The Morgan Stanley trader asked UBS to keep the trade
quiet -- a violation of New York Mercantile Exchange (Nymex)
rules -- until after the 2:30 p.m. close of trading that day.
Secret Deal
The secret deal was breathtakingly large, equivalent to 12
percent of March futures on the Nymex. At the end of the day,
USO and its investors lost because of the extreme contango: They
could afford fewer of the more expensive April futures than they
had in March, Forero says after analyzing Bloomberg data. Buying
the same amount of oil would have cost $466 million more, he
estimates. "You can either get screwed out of money or you can
get screwed out of product," he says. "They had to pay more
for effectively the same barrels."
The CFTC told the oil fund it may be held "vicariously
liable" for UBS's actions, according to a March filing with the
SEC. Hyland says he knew nothing about the deal. In April the
CFTC ordered a $14 million civil fine for Morgan Stanley and
$200,000 for UBS for failing to report the trade as required.
The CFTC declined to explain how it arrived at the amounts or to
disclose Morgan Stanley's profit. "Morgan Stanley fully
cooperated with the CFTC and is pleased to have reached a
resolution with our regulator," says company spokeswoman
Jennifer Sala. "This matter concerned an isolated request by a
former Morgan Stanley trader."
Revealing Risks
Without knowing Morgan Stanley's trades, Hyland says, it's
hard to determine whether the bank's actions harmed investors.
"The best that you can do as the provider of investment
products is lay out, in as much detail as you think people can
absorb, the hows, the whys, and the risks," he says. Page five
of the fund's 86-page prospectus includes this disclaimer: "The
price relationship between the near month contract to expire and
the next month contract to expire _ will vary and may impact
both the total return over time _ as well as the degree to which
its total return tracks other crude oil price indices' total
returns."
Hyland's other main fund, U.S. Natural Gas (UNG), got so
big last year that at its peak it owned the equivalent of 86
percent of the near-month natural gas contracts on the Nymex. As
natural gas prices fell into the basement -- traders call the
notoriously volatile market "The Widowmaker" -- UNG fell with
them, and when gas prices rallied, UNG did not. The fund's
growth raised concerns among regulators at the CFTC, which last
year began debating position limits; it will revisit the issue
this year. The fund grew so large it had to freeze its position
and start buying over-the-counter derivatives -- unregulated
contracts tied to gas prices -- instead of futures. Hyland told
the CFTC last year that it was "gibberish" to say UNG had any
effect on natural gas prices.
Wall Street Overhaul
The financial reform bill President Barack Obama signed on
July 21 includes a few provisions that may help the CFTC address
the commodity ETF mess. The new regulations enhance the CFTC's
ability to prosecute trading abuses, and set position limits on
over-the-counter swaps, like those UNG has been buying. How much
the new law will help remains to be seen, says Jill E. Sommers,
one of the agency's five commissioners, because Congress still
needs to appropriate funds and write guidelines for
implementation and enforcement. "We'll need additional dollars
to carry this out," she says, adding that it's too early to say
whether the CFTC has the authority needed to crack down on pre-
rolling. "We're at the beginning of the rule-writing process,
so it's premature to say whether additional authority is going
to be needed," she says.
Supersized Role
By requiring the commission to impose caps on energy
trading within a year, the rules may limit the size of some
funds. It does nothing to directly address the market impact of
the funds, says CFTC commissioner Bart Chilton. He likens ETF
investors' supersized role to the one Tom Hanks played in the
1988 film Big -- a little boy in a man's body. "The dynamics of
the market have changed so dramatically over the last several
years with this new influx of capital that is massive in size
and passive in strategy," Chilton says. "That has had an
impact that wasn't anticipated."
The CFTC's explicit responsibility is to guard against
commodity market distortions, not to look out for ETF investors
like Gordon Wolf. "We are concerned about both," says Sommers.
Adds Gensler: "The CFTC is aggressively using its authority to
police the markets for fraud, manipulation, and other abuses.
Investors also should fully research any products before they
buy." As Hyland likes to point out, the risks are described in
each fund's prospectus. Now investors are learning what those
words actually mean.
For Related News and Information:
Top Commodity Stories: CTOP <GO>
Top Oil Market Stories: OTOP <GO>
Exchange-Traded Products: EXTF <GO>
Derivatives Stories: NI DRV <GO>
U.S. Oil Fund Stories: USO <Equity> CN BN
Commodity Futures Trading Commission: NI CFT <GO>
Oil Prices: CL1 <Commodity> GP <GO>
U.S. Oil Fund Performance: USO US <Equity> COMP <GO>
U.S. Natural Gas Fund: UNG US <EQUITY> CN BN <GO>
--Editors: Flynn McRoberts, Robert L. Simison.
To contact the reporters on this story:
Peter Robison in Seattle at +1-206-913-4544 or
robison@bloomberg.net;
Asjylyn Loder in New York at +1-212-617-5771 or
aloder@bloomberg.net;
Alan Bjerga in Washington at +1-202-624-1857 or
abjerga@bloomberg.net.
To contact the editors responsible for this story:
Gary Putka at +1-617-210-4625 or
gputka@bloomberg.net;
Dan Stets at +1-212-617-4403 or
dstets@bloomberg.net
