Many Small Investors Duped by WTI Futures ETF
ETFs can be a nice tool for investors to participate in markets that they normally wouldn’t, like WTI oil futures. We need to look at the ingredients of these ETFs first.
Your average investor doesn’t pay much attention to the futures markets, whether this be oil futures or any of the many other commodities and indexes that are traded in these markets. Only people who partake in these markets regularly have accounts that you can use to trade them, and you can’t just trade in futures with your regular brokerage account.
It used to be that you would also need a fair bit of money to commit to futures, and given that investors will still want to keep most of their money in their regular investments, anything that they commit to futures will need to basically be play money, a fairly small portion of their overall portfolio that they can afford to set aside to play around with futures contracts.
This used to require that we trade with full contracts, the same ones that the big people trade, even though they trade in many more than just one at a time. Still though, only the wealthy have the means to trade full contracts and still have the amount of money that they need to dedicate to this representing a small enough percentage of their overall investing money to be reasonable and in accordance with both their abilities and risk tolerances.
This shut out most people, and the futures exchanges recognized this. They saw some real opportunities with retail investors, ones that do not have the means to trade full contracts but may be enticed by mini or even micro contracts, bringing down the amount that you need to put down as a deposit on a futures trade to within much easier grasp of many more investors.
The focus here has almost entirely been on the major stock indexes, with the S&P mini being particularly popular. This is at least down the same alley as the things retail investors already invest in, and you do need some idea of what you are doing to trade in futures, and in particular, be fairly familiar with the underlying asset. A lot of people follow stock indexes though and they are very prominent in the media, so this was a natural fit.
Trading in oil futures is a different deal altogether though, and while a good trader can trade anything just by looking at a chart, and what the asset is may not even matter, we’re not talking about skilled traders when it comes to investors taking a shot at this. Investors need to be very careful with futures, as you don’t buy anything here, you just put up money to cover a position you take, and you can lose all of your deposit and more if you aren’t careful.
This is what really distinguishes the skilled from the unskilled when it comes to futures trading, where it is not so much when to get in that matters, but instead, when to get out. Managing risk is essential to success in futures trading, even more so than with investing, where you can even ignore risk completely and just hang on and hope, where over time these hopes usually turn out pretty well, even though this approach may not be the best.
You can’t get by with this sort of thinking with futures though, as mistakes with futures can be very costly, and they definitely do require active management, and good active management. Anyone long oil lately will readily attest to this, as the normal amount of danger with this trading got magnified many times lately as the price of oil tanked.
If you let a futures position go against you by 20%, and oil has dropped several times more than this lately, this is not like seeing your stock portfolio drop by 20%, which may not even bother investors much if at all. With futures, you’ve not only lost all of your money, you owe your broker even more than what you lost, who have closed your position on you and send you a bill for the rest if you don’t have it in your account for them to take.
The risk with futures trading is therefore much higher, even if you just go with a smaller contract. It’s higher with oil futures than anything else, due to the higher volatility of oil compared to other things you can trade futures with, and to just say that this risk has gone higher would be quite an understatement.
When the amount that it would take to wipe you out and then some is a daily occurrence now, much greater care needs to be given to this trading, and this is nothing that we should want to do without the means to watch this market closely and be prepared to act at any time in such wildly changing conditions. This is not something to be traded casually, especially without proven trading skills, as we can neither watch things to act when we need to or even know how to act when we need do.
While the idea of our being able to trade oil futures by way of exchange traded funds, or ETFs, is something that a lot of investors have found to be pretty appealing, given that these are things you don’t need a special account to trade and the fact that they are much safer than the leveraged futures trading that these traders engage in.
The United States Oil Fund, or USO, the biggest oil ETF by far, has now become a popular choice among many retail investors, especially among millennials who may have been pointed this way from social media. You learn about this, you share it with your friends, you see it talked about online, and you decide that playing with oil right now is a tempting choice, and many have been tempted.
Given that USO is supposed to track the near term WTI contract, and is supposed to switch away from the expiring contract two weeks out, and isn’t leveraged, this might seem like a good idea for those who may want to play the rebound that they expected as the price of oil got beaten down further than they think it should.
While these casual investors are thinking that they are stepping up and probably grabbing some easy money by looking to play a bounce in oil, and don’t realize how much that they don’t know about oil trading or futures trading, they usually haven’t looked into the actual structure of this ETF, and making an extra mouse click to look at the holdings of the fund was even beyond their threshold of diligence.
Pig in a Poke Style Trading Doesn’t Work So Well
We should never buy an ETF without at least peeking under the hood, and they are required to be transparent about this, but if we don’t look, it doesn’t matter. As it turns out, this fund is not exactly like what they tell you on the sales page, and differs quite a bit in fact, in ways that really matter.
This is not a fund that anyone should be investing in of course, given the trajectory of oil lately, but even if we aren’t looking to hold it for very long, we need to be aware of how much this fund underperforms the oil market, even to the point where it’s even hard to figure. This already should be a big enough red flag for us to steer away from it completely, even at times where we may be as tempted as people have become.
The fund losing two thirds of its value this year so far should not surprise anyone, but the fact that this fund has been around for 14 years now and has lost 97% of its value over these 14 years should startle us perhaps like nothing other in the investment world. Sure, oil has gone down in price over these years, but not by this much, not even close. USO had already lost 85% of its value between April 2006 when the fund started and the beginning of 2020, which tells you that there are things that are far more wrong with it than just this recent plunge.
We don’t even need to look into why when something underperforms the underlying asset that they are supposed to be tracking by such a massive amount. If we bought a stock fund that is supposed to track the S&P 500, and the index goes up but we lose a bunch of money instead, it just isn’t tracking it well, and not even close. This needs to put an end to any idea that this tracks the index completely, when it shows itself to fail so utterly.
When we hear things such as this index falling more than the market recently and subsequently only capturing a fraction of the rebound, as people are recognizing now, we should not be surprised. This just does not track WTI futures well and in fact does a horrible job of it.
We could look at any number of comparisons to show the discrepancy with this fund and the performance of the asset that is supposed to be tracked, and even though we would expect the fund to underperform a little due to management fees, the difference can only be explained by mismanagement, and not just a small dose of it.
This gap really shows itself over time, and is also a better way to see how something really stacks up to the asset it is supposed to track. Since the peak of 2008, WTI has fallen a lot over this time, by 90% now. A $10,000 investment in it back then would only be worth about $1000 today. That’s gruesome enough, but considerably better than what has happened with USO.
USO has lost a shocking 98% over this time, leaving us with only $200 of our $10,000 left. Aside from this making clear of how stupid of an idea if would have been to invest in either over all these years, only being left with 10% of your original investment is bad enough, but 2% is a lot worse, and shows just how poorly this ETF tracks WTI over time, over 12 years in this case.
We don’t have to look any further, as USO not only goes down more than WTI does, it goes up less, and the combination is a very ugly one. The real reason, or at least a big one, why we’re not tracking up with USO the same way that WTI has is the fact that USO does not have all or even the majority of its money in the June WTI contract, it only has a fairly small portion of its assets in this, along with assorted other oil investments, with the majority of their assets sitting in cash and in U.S. treasuries.
They also took a hit from the May contract, even though they were supposed to be out of it two weeks prior. What actually had USO make the news recently was the fact that, in the final hours of trading with the May contract, most of the contracts were held by the USO fund. This fund steers completely clear of physical settlements so they were left to dump a lot of their holdings at the worst time to do this in history, by a wide margin.
This explains at least somewhat the particular bashing that the value of their fund took, but particularly shows us how much they leave the road with this fund. This is not just the inmates running the asylum, where individual investors foolishly hung on to this, perhaps not even knowing what is going on, as this was supposed to be rolled over to June some time ago.
USO Clearly Has Not Stuck to its Stated Objective Lately
Two weeks prior, when they were supposed to be all in the June contract, WTI June traded at $29.20. It has taken a hit of course, and 41% is painful enough if you are on the long side, although you could have been on the other side of this trade and made that much. The USO, on the other hand, lost 52%, which might not seem like much of a difference, but 9% in just two weeks surely is. When you compare the two on any timeframe over any period, USO gets kicked around like a dog at every glance.
The fact that they meddled with a contract that collapsed at expiration certainly contributed to this, and even though it was not that they had all that money lingering around the May contract, this certainly contributed to this 9% difference in two weeks.
Now that they hold so much cash, this is where the retail investors come in, seeing the rebound and logging into their Robin Hood accounts hoping that Robin will take some of all the money that these rich oil barons have and put a little of that in their pocket as oil rebounds. When you are over half diluted though, don’t expect much.
We shudder to think that these retail investors were in this fund prior to the rebound, during the ongoing collapse phase where they have averaged over a negative 10% return over the last 10 years, as we’re supposed to leave the losing to the big companies that buy a lot of oil, and we need to be on the other side of these losing trades, not join them. Some quick math tells us that 10% a year for 10 years is 100%, and while you can’t lose it all while the price is above zero, USO has come very close, and sits barely above zero as we speak.
This is clearly not the vehicle that you want to use to experience the rebound that you think is coming, as investors who had thought this are now coming to learn, hopefully anyway. It is not that oil is bullish right now anyway, or that much more of a rebound is probably in store, and WTI may do well to hold its recent gains that were only caused by the panic of the previous contract, fueled in large part by USO themselves.
The great majority of the May contracts were already closed out on this day, as the bigger players are not crazy enough to let the clock wind down and expose themselves to even bigger losses than they already suffered, but USO apparently is bold enough, well beyond what is sensible.
Oil trading right now needs to be left to those who either have a need pressing enough to take on the risk or to those with the skill and expertise to trade it properly. USO has not shown that it can deliver even if the conditions are right enough, and far from it, as they can’t even track what they are supposed to track in a way that is even close.
In spite of the oil market settling down more over the last few days, make no mistake, there is a real war going on here and the price of oil remains very much under attack. This is not amateur hour, and especially on the long side which is not where the smart money is looking to commit to very much aside from capturing moves like the one in the aftermath of the collapse of the May contract.
Even the pros need to proceed much more cautiously with this contract than normal, and this is surely not something that you want to take a position with on either side without very careful management, having your hand on your gun at all times instead of just casually looking to play a bounce on the long side like these retail investors want to do.
Trading oil can be plenty fun, but not so much fun when you don’t do well, and the idea may seem like a fun one right now, but this is not the time, especially with a terrible ETF like USO.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
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