Risks Associated With Futures Based ETFs

Introduction

All ETFs own underlying assets, but what they own varies based on the type of ETF:

There are special risks associated with any ETF that is futures based. This article explains those risks.

Risk #1 - Tracking error

A commodities related ETF like UNG is designed to track the movements of natural gas prices. But because it wouldn't be practical for the fund to actually own and store in a warehouse natural gas, the fund instead buys natural gas futures - the right to take delivery of natural gas at a future date. Because the fund doesn't want to actually take delivery of the natural gas when the future expires, the fund has to sell the futures it owns at some point before the actual delivery date arrives. So the fund is constantly buying and selling futures. When you buy shares in UNG, you are in essence buying the natural gas futures that the fund currently owns.

The hope was that UNG's fund managers could somehow buy and sell futures in a way that would replicate the actual movement in natural gas prices. But it is hard to do. And we use UNG as an example but all futures based ETFs face the same challenge: it's hard to manage the buying and selling of futures in a way that will successfully track the index the ETF would like to track.

The energy related ETFs like UNG and USO, which tries to track the movement in the price of oil, are known to have a poor track record in terms of successfully tracking the actual movements in the price of oil or natural gas over the long run. So when you are looking at buying a futures based ETF like USO or UNG, you have to constantly remind yourself that you are actually buying futures that may or may not accurately track the true price of oil and natural gas.

Risk #2 - Poor Performance Due to Contango In The Futures Market

Contango is a funny term that gets used, but let's first explain it in simple terms. As explained above, UNG and USO are constantly buying and selling futures. The problem is that over the long run these funds inevitably lose money during the course of this trading in futures that has nothing to do with the actual movements in the price of oil or natural gas. So the price of oil or natural gas may go up 10% during the next 6 months, but the value of USO or UNG may only go up 5% during this time period because the funds will lose 5% in the course of the underlying trading in futures. Why do they almost always lose this money on the futures trading? Because the futures market is typically in a state of "contango".

Now let's explain contango in more complex terms. To quote Wikipedia:

Contango is the market condition where the futures price (or forward price) of a commodity is higher than the current spot price. A contango is normal for a non-perishable commodity that has a cost of carry. The opposite market condition to contango is known as backwardation. A market is 'in backwardation' when the futures price is below the expected future spot price for a particular commodity.

Why does contango create poor performance for an ETF like USO or UNG? If USO owns 1,000 futures contracts that have a delivery date 30 days from now, USO will need to sell those contracts, because they don't want to take delivery of the oil. So they sell those 1,000 contracts. But the fund has to stay fully invested in oil futures, so the fund then has to buy 1,000 futures contracts that have a delivery date 60 days from now. Because of contango, they will lose money on this trade because the futures with a delivery date 60 days from now will cost them more than the futures they just sold with a delivery date 30 days from now.

Can an ETF prevent poor performance due to contango? Maybe. Some ETFs are trying to minimize the effects of contango by buying and selling different types of futures with different future delivery dates. UNG only buys short-term futures or so-called front month futures - futures with upcoming delivery dates. UNL, on the other hand, buys futures with delivery dates spread throughout the upcoming year. The difference in performance between UNG and UNL can be significant, as shown by this stock chart:


Conclusion

UNG was one of the first natural gas ETFs, so it is popular. But you should not own UNG for any extended periods of time because over time it does not perform well. So it is more of a short-term trading vehicle rather than a long-term investment. The ETF industry is still working at figuring out ways to enhance futures-based ETFs to minimize the above risks, so alternative approaches like UNL are being developed. But it may take some time for the industry to truly figure out these issues. So as an investor you need to be careful.


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