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Leave the new oil ETF to the pros
Buying individual commodities is for the experts, even when risk is diluted in an exchange-traded fund. Here are safer ways to ride the commodities boom.
By Timothy Middleton
China is poised later this year to begin operating what it calls "Artificial Sun," a reactor that Peoples Daily asserts "can generate infinite clean nuclear-fusion-based energy."
The reactor uses a superconducting technology called Tokamak. "While there may be no shortage of energy in the future if and when Tokamak works, there are plenty of shortages of key industrial commodities today as the global economy continues to boom," says Edward Yardeni, chief investment strategist for Oak Associates.
The booming markets for energy and basic materials have fueled a burgeoning demand for ways to invest in them. The latest is the United States Oil Fund (the ticker symbol for which will be "USO"), an exchange-traded fund that is due to begin trading this week. It represents a pure play on the price of oil -- up nearly 30% in the last year -- which until now was limited to the high-risk market for futures and options.
Aside from the fact that now is probably a better time to be selling oil than buying it, I think U.S. Oil Fund represents the kind of overspecialization that does little other than create yet another revenue stream for the fund industry.
Except for a handful of experts, industry funds are too narrowly focused to benefit small investors. I prefer more-diversified natural-resources funds, both mutual- and exchange-traded. But the commodities theme is certainly worth investing in, so checking out new commodity funds is instructive.
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The new oil fund trails by two months the launch of DB Commodity Index Tracking (DBC, news, msgs), an ETF that follows the broad commodities markets, including agricultural products as well as petroleum and metals.
In coming days, Barclays Global Investors plans to unveil iShares Silver Trust (which will have the ticker symbol "SLV"), a pure play on that metal. That follows the hugely successful introduction of StreetTracks Gold (GLD, news, msgs), a way to own physical gold rather than shares in gold-mining companies.
The sudden interest in commodities follows more than two decades of neglect during which little new oil was discovered, no domestic refineries were constructed and such industries as paper and mining couldnt afford capital investment.
So todays demand has already outpaced supply, and it could take years for new production capacity to be added. Meanwhile, as Yardeni noted in a memo to his firms clients last week, there has been a "wave of panic buying by industrial users."
The auto industry is gobbling up platinum, copper and steel. Aviation is consuming aluminum and titanium. And unless and until China can make fusion work, it is buying fossil forms of energy at rates that could equal U.S. demand within decades.
Enter the ETFs
Exchange-traded funds are a simple way to offer commodities to individual investors. ETFs track indexes, which means expensive active management isnt needed. Shares cant be redeemed by individuals -- only sold on an exchange, like the American Stock Exchange in the case of U.S. Oil Fund -- so assets dont have to be liquidated in falling markets. With traditional mutual funds, individuals who sell shares actually shrink the size of a fund. That forces fund managers to sell shares of companies they own.
U.S. Oil Fund will track the market for West Texas Intermediate light, sweet crude oil delivered in Cushing, Okla., a popular futures contract. Specifically, its per-share price will mimic the price of futures on the New York Mercantile Exchange.
As of March 7, when the U.S. Oil Fund prospectus filed with the Securities & Exchange Commission was written, that price was equal to $61.58 per barrel. That price last week was around $66.75.
According to the prospectus, the futures contracts in which it would invest represent 100 barrels, and thus cost 100 times the per-barrel price. Thus fund shares, which represent a single barrel, are far more affordable to individual investors.
The fund is a commodity pool, and its manager is Victoria Bay Asset Management. This is indirectly owned by Nicholas Gerber, manager of Ameristock (AMSTX), a mutual fund that invests principally in large-capitalization stocks. Formerly, he was a floor trader with the New York Futures Exchange.
Although U.S. Oil Fund is indexed, it is expensive to operate, with Gerbers company earning a management fee of between 0.3% and 0.5%, depending on total assets under management. Usually, ETFs have total annual expenses of less than 0.35%.
Market effect
Because it invests in derivative financial instruments rather than physical ownership of petroleum, U.S. Oil Fund should not by its mere existence have any effect on the price of the investments it owns.
That was not the case with StreetTracks Gold which, as I explained in February ("Gold's big run is almost over"), has become the worlds largest private owner of bullion, driving up the price as it acquired the metal.
Similarly, the pending launch of iShares Silver Index helps drive the price of the metal, which was $11.30 an ounce at noon last Thursday, as the fund acquires enough of the metal to back up its shares.
According to its preliminary prospectus, Silver Index shares will represent 10 ounces of silver, suggesting a current per-share price of $113.
Exchange-traded funds can vary from the indices they follow because their share price can diverge from the net asset value (NAV) of their holdings, creating a premium or discount to NAV.
In the case of StreetTracks Gold, it tends to trade at a slight premium to NAV. In the 12 months ended March 30, the funds share price advanced 37.5%, 1.2 percentage points more than the 36.3% rise in the price of gold bullion.
A cheaper silver lining
The proliferation of commodity-linked ETFs opens, therefore, the opportunity for them to have unintended consequences in the markets in which they invest. But where that risk does not exist, as with U.S. Oil Fund, they appear to be a simple and not terribly expensive way for individuals to participate in these markets.
Other investment options can be more difficult, expensive and risky. Last week I called a specialist in futures and options, a firm called Lind-Waldock, and the first thing the broker said to me was: "I would not invest in crude right now. Its coming off a peak. This is such a volatile market."
He pointed out that a five-cent drop in the per-gallon price of crude, which had just occurred, would have cost me $50 on a single futures contract. For $10,000, I could have bought two of them on margin and lost $100.
At least, the ETF reins in the magnitude of this risk. A five-cent drop in the price of U.S. Oil Fund would have cost me about $7.50 on a $10,000 investment.
Similarly, if you want to buy silver today with the expectation its price will rise as iShares Silver Trust creates new demand, forget about it. In the first place, this has already occurred: The price of silver was only $9.22 an ounce last December, before Silver Trusts preliminary prospectus was filed. It recently climbed past $11 per ounce.
In addition, you would pay a bundle in transactions costs. When I called Kitco Precious Metals last week, it reported that a 1,000-ounce bar, the smallest available, would cost $11,440 plus about $300 for shipping and insurance. I could sell it back for $11,220, and could expect to pay another $300 for shipping and insurance.
The round trip on 1,000 ounces, therefore, would be $820, or 7.17% of my total investment.
If I had bought the ETF when silver was at the same price, the bid-ask spread on the shares would have been a quarter-point and my round-trip commissions $20. That friction would have eaten up only $88.66, or 0.77% of an investment of similar size, about 10% as much as the trade of the metal itself.
So shaving friction costs to the bone is a very valuable service that ETFs do perform. I would expect, however, that only the most broadly diversified funds, such as iShares Goldman Sachs Natural Resources (IGE, news, msgs), will appeal to most investors. My model portfolio of ETFs owns this fund.
Like T. Rowe Price New Era (PRNEX), GS Natural Resources invests in things other than energy, such as paper companies and copper mines. Making bets on individual commodities, it seems to me, is suitable only for experts in those fields.
At the time of publication Timothy Middleton didnt own any securities mentioned in this article.
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