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Is this America's worst investment?

http://articles.moneycentral.msn.com/Investing/MutualFunds/is-this-americas-worst-investment.aspx
Investors have poured billions into exchange-traded funds that attempt to track the prices of raw materials. But when commodities go up, commodity ETFs often don't.

[Related content: ETF, investing strategy, mutual funds, oil, gold]
By Bloomberg Businessweek
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, Calif., Wolf was a buy-and-hold sort of guy, yet the nest egg he had entrusted to his broker at Merrill Lynch was down more than 50%. The broker had invested much of it in exchange-traded funds, or ETFs, a financial innovation that was replacing mutual funds in the hearts and portfolios of many investors.


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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.

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The commodity ETFs were supposed to offer a hedge against equity losses, but in the crash of 2008, everything fell in tandem. As oil declined to $34 a barrel in early 2009, Wolf sensed an opportunity. He called his broker and asked about U.S. Oil Fund (USO), an ETF designed to track the price of light, sweet crude. Wolf had the broker buy about $10,000 of USO.

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What happened next didn't make sense. Wolf watched oil go up, as predicted, yet USO kept going down. Crude rose 7.4% in February 2009 while USO fell by 7.4%. What was going on? Wolf logged on to Seeking Alpha, a financial blog, and found plenty of angry discussions 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.

Investors by the end of 2009 had put a record $277 billion in commodity ETFs and other securities linked to raw materials -- a huge 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 hypervolatile investment that can steal your shirt to a booster for battered portfolios, something that rose when stocks fell and hedged against inflation.

People who would never think of buying a tanker of crude oil or a silo of wheat could now put both commodities in their 401k'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. 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. "I don't know what it is," he replied.

Wolf called his other broker, at Charles Schwab (SCHW, news, msgs). "He didn't know either," he 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."

The contango trap
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 because of contango -- they lose money for their investors. Contango eats a fund's seed corn, chewing away its value.

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 and push 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, the 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.

The biggest oil ETF, the U.S. Oil Fund, which has $1.9 billion invested in it, has dropped 50% since it started in April 2006, even as crude oil climbed 11%. The $2.7 billion U.S. Natural Gas Fund (UNG), offered by the same company, has plummeted 85% since its launch in April 2007, more than double the 40% decline in natural gas.

Deutsche Bank's PowerShares DB Agriculture Fund (DBA) has eked out a 3% total return since January 2007, while the weighted average of its commodity components has risen 19%. 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 big investors. The California Public Employees' Retirement System, the nation's largest public pension, has lost almost 15% of an $842 million investment in commodity futures since 2007, 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, a former director of commodity trading at UBS (UBS, news, msgs). "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, the managing director of Cervino Capital Management, a commodity trading adviser. Turning commodity futures into securities unleashed a much larger sales force -- stockbrokers selling a product that 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.


Airlines' new $25 charges for checking suitcases exists partly because the carriers have to set aside cash to hedge against sharper ups and downs in oil prices, says Bob Fornaro, the chief executive of AirTran Airways (AAI, news, msgs). "This has been very, very good for Wall Street," he says.

Sponsors of commodity ETFs and similar investments, including Deutsche Bank (DB, news, msgs), Barclays (BCS, news, msgs) 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 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 United States.

Not every trader is comfortable with what Wall Street has done. Forero, 36, became the director of commodity trading at UBS in 2007. A New Yorker whose father was the Colombian consul to the United States, he worked a series of energy-trading jobs before landing at UBS' securities division in Stamford, Conn., where the Swiss bank operates one of the world's largest trading floors.

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. 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 house in Norwalk, Conn. With no job, Forero holed up at home, sifting through data. He became convinced that the products UBS had sold were hurting investors and disrupting supply and demand for basic commodities.

"I've always been a little naive, 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."

The birth of an idea
Bob Greer spent time in the 1970s in a library in Tulsa, Okla., going through microfilm and piecing together the first investable commodity index. Greer had worked at a commodity brokerage in Dallas, where he got the idea that raw materials might belong in investment portfolios.

Greer published his first article on buy-and-hold commodity investing in 1978, outlining the benefits of passive, unleveraged, long-only bets on raw materials. The idea didn't catch on; everyone knew someone who had gone broke betting on soybeans or a gold bug who hoarded coins against catastrophe, says Greer, now 63 and an executive vice president at Pimco in Newport Beach, Calif.

Greer had given up on his idea when Goldman Sachs (GS, news, msgs) launched its benchmark commodity index in 1991 and began selling swaps that tracked it to institutional investors. Commodity 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 Index ($INX) plunged 25%, investors were desperate for alternatives. That year, Pimco hired Greer to start its Commodity Real Return Strategy Fund (PCRAX). The actively managed fund has returned more than 200% since its debut.

While Greer was launching his fund, an Australian natural-resources consultant, Graham Tuckwell, was developing the first commodity ETFs. Tuckwell had worked in finance and by 2002 was working at the Australian Gold Council, looking for a way to encourage gold investing. An acquaintance mentioned an oddball product: wine securities, which allowed cases of a particular vintage to be traded on a stock exchange. Instead of cases of wine, the shares in Tuckwell's fund would be backed by gold bars stored in a vault.

Tuckwell's innovation, Gold Bullion Securities, became a hit, and in April 2004 a contact at Royal Dutch Shell (RDS.A, news, msgs) approached him to ask whether he could do for oil what he had done for gold. Tuckwell went to Shell and pitched a product that would help the company make money from the crude it kept in storage.

Banks used new academic research to pitch commodities as a safe way to diversify. In a 2004 presentation, Heather Shemilt of Goldman called the strategy "the portfolio enhancer." That same year, two professors, Gary B. Gorton of the Wharton School at the University of Pennsylvania and K. Geert Rouwenhorst of Yale University, published a paper, funded in part by American International Group (AIG, news, msgs), that said 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.

Barclays, Goldman, AIG and other companies had developed ways to help investors get in, producing 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.

There was an obstacle: The U.S. Commodity Futures Trading Commission, or CFTC, a regulatory board created in 1974 after a run-up 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. 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 and Feed Association conferences to introduce ETF investors to the traditional players, such as farmers and silo operators.

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 commodity prices to rise without having to roll contracts, giving them another advantage over ETF investors.

Goldman owns a global network of aluminum warehouses. Morgan Stanley (MS, news, msgs) chartered more tankers than Chevron (CVX, news, msgs) last year, according to shipbroker Poten & Partners. And JPMorgan Chase (JPM, news, msgs) hired a supertanker to store heating oil off Malta last year, likely earning returns of better than 50% in six months, oil economist Philip Verleger says.

"Many, many firms did this," Verleger 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.

How traders would pick USO apart
John Hyland, 51, had been in the investment business for 20 years, running portfolios and mutual funds, before he teamed up in 2005 with U.S. Commodities CEO Nicholas Gerber. 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 the CEO of Bear Hunter Structured Products, which was to be the fund's first market maker. 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.'"


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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. At an ETF conference in Boca Raton, Fla., 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," Hyland 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 such as Wolf had flocked to the fund; its monthly roll, taking place that day, had grown so large that it represented financial contracts for nearly 78 million barrels of oil, roughly four times the amount of oil consumed in the U.S. in a day. The Feb. 6 price spread between expiring crude-oil futures and those for the following month widened by $1.39 a barrel, or 30%, 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, or Nymex, rules -- until after the 2:30 p.m. close of trading.

The secret deal was breathtakingly large, equivalent to 12% 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' 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. UBS declined comment.

"Morgan Stanley fully cooperated with the CFTC and is pleased to have reached a resolution with our regulator," company spokeswoman Jennifer Sala says. "This matter concerned an isolated request by a former Morgan Stanley trader."

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 5 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% 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 widow-maker" -- 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.

The financial-reform bill President Barack Obama signed 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."

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," Sommers says. 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.

This article was reported by Peter Robison, Asjylyn Loder and Alan Bjerga for Bloomberg Businessweek.

http://articles.moneycentral.msn.com/Investing/MutualFunds/is-this-americas-worst-investment.aspx