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Why Commodity ETFs Work Better Than You Thought

In a previous article, we reviewed some of the factors that determine the price of a futures contract, including the spot price, borrowing costs (time value of money), storage costs for physical commodities, and any convenience yield ( "What Determines Futures Prices?").

Once you understand that futures prices are driven by more than just the spot price, it is possible to remove some of the confusion about securities products that use futures to track the price of important commodities. First, let's review the claim about tracking error in exchange-traded products (ETPs), and then explain why those products function better than many investors realize.

A common tactic for skeptics of ETPs that track commodities like crude oil or natural gas - think of USO or UNG - is to show the change over some period in the spot price of the commodities and compare that change with the return achieved by the ETPs. Inevitably, the tradable products perform "worse," often seemingly dramatically so. This leads frequently to claims that such products are "broken" or not useful - not because the investment thesis in the underlying commodity was wrong, but because the tracking funds did not deliver the returns they were supposed to.

The problem with any spot-to-ETP comparison of this sort is that time series of spot prices does not reflect the real costs to holding a physical commodity. In a sense, the spot market does not exist: the total return for a commodity bought on the spot at time zero will not, at any time one, be exactly that of the change in spot price by time one. To see why, imagine going out and buying some natural gas right now on the spot market. Where are you going to store it? Storage space is not free; in fact, in 2012, there was such a glut of natural gas supply that investors were justifiably troubled by the prospect of gas E&P companies burning off their surplus to resolve the dilemma of insufficient storage and the potential loss of drilling rights if they let land lie dormant. If you decide you've had enough one day, you'll also need to transport your gas to a place where there is someone who wants to buy it, or lower your sale price to reflect the buyer's transport costs. Additionally, the time spent owning any commodity is time that the money used to buy that commodity isn't earning the risk-free rate of return; if the money to purchase was borrowed, the cost of that capital creates an additional headwind.

As we saw in the previous article, the spot-futures parity relationship tells us that the real costs that would be borne by someone who bought the commodity today in the spot market will be reflected in the prices of futures contracts for that commodity. An investor who wants to own that commodity can expect to pay those costs, no matter whether they buy the physical stuff and store it, buy and roll futures contracts, or buy an ETP that buys futures and/or the physical stuff. If the futures are in contango - if costs to ownership increase with time - and if the spot price of the asset does not change very much, then it is even possible for the returns to a commodity investment to be dominated by these non-spot factors the longer the investment is held.
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