By Tim Hesselsweet
Stock quotes in this article: DBO, USO, OIL, DBA, DBE, DBB, DBS, DBP, DBC
"Crude Oil Tracking Error", I explained some of the difficulties of investing in crude oil. While spot crude oil prices may be informative, there's a difference between buying crude oil for an industrial process (conversion into products such as gas and heating oil) and buying crude as an investment. Once you purchase crude, you have to store it and that incurs a cost that eats into your return. Spot crude "returns" are fictitious in the sense that you can't realize them as an investor.
ETFs that offer exposure to crude oil typically use futures to gain exposure to crude. Using futures and rolling from one contract to another as it nears expiration eliminates the messy storage problem. Futures returns have three components. First when you fund a futures account, you buy short-term treasury bills (usually 3-month or 6-month) that can be used as collateral for trading futures. Changes in spot prices are the next component and the only one most people consider. Finally there's a roll yield determined by the term structure of the futures contract. When distant contracts are priced less than near contracts (backwardation), you'll realize a positive roll yield and when distant contracts are higher than near contracts (contango), you'll realize a negative roll yield.
If you read the fine print in ETF prospectuses, you can find out what "index" each ETF attempts to track. The United States Oil Fund(USO_) and the iPath S&P GSCI Crude Oil Total Return Index ETN(OIL_) rolls front-month crude futures. The PowerShares DB Oil Fund(DBO_), uses a roll-optimized strategy. When it's time to roll, rather than simply rolling to the next month contract, DBO looks at the crude oil term structure and find the contract that will maximize backwardation or minimize contango (as is the case currently). Here are the year-to-date returns for each:
More on DBO
This shows the significance of an effective roll strategy. I recommend the PowerShares family of commodity ETFs as a better way to get commodity exposure without having to trade futures. PowerShares also offers the DB Energy Fund (DBE_), DB Base Metals Fund(DBB_), DB Agriculture Fund(DBA_), DB Silver Fund(DBS_), DB Precious Metals Fund(DBP_), and DB Commodity Index Tracking Fund(DBC_).
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Tim has a B.S. in math from the University of Texas and a master's in statistics from Columbia University. He currently runs his own CTA after being a futures portfolio manager for several well-known hedge funds. Tim's foundational approach is that statistical trading must be grounded in financial and economic intuition. His writings are an exploration of both markets and quantitative methods.
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