When investors noticed that their stock mutual funds had lost value — lots and lots of value — they moved their money into commodity ETFs. But that wasn’t simply a case of closing the barn door after the horse had bolted. They also found out the hard way that when commodities go up, commodity ETFs often don’t:
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 2010, 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.
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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. The $2.7 billion U.S. Natural Gas Fund (UNG), 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 (DB) PowerShares DB Agriculture Fund (DBA) 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.
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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.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 (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.”