Deep Dive into a Commodity-based ETF

by Jay Pestrichelli on September 10th, 2012

 For those of you familiar with ETFs, you understand that these securities can represent a basket of stocks, trade intra-day like a stock, and provide a many advantages over mutual funds. But what many people don’t realize, is that an ETF may also be comprised of derivative holdings like futures or commodity contracts.
I bring this up because of the outperformance of UGA (gasoline ETF) compared to the underlying RBOB gasoline futures. In order to get a better understanding of why this is the case, I called the fund company for an explanation and it goes to the construction of commodity based ETFs.
Typically, commodity based ETFs have a slight tracking error against the underlying commodity due to the price differences between monthly spot prices. A good example of this is OIL. The spot price of Light Sweet Crude is up 8.37% over the last 12 months compared to OIL, an oil based ETF, which is only up 4.3%.
This tracking error is typically due to the price of the forward month price being more expensive than the current month price. This is known as “contango”. Here are the barrel prices for the next few months for Light Sweet Crude (WTI)
Oct 2012:       96.53
Nov 2012:      96.82
Dec 2012:      97.17
Jan 2013:       97.60
Feb 2013:      98.05
Some of this is due to the storage price of the commodity for those that need to deliver the actually commodity itself as well as the speculative nature of the traders. For a fund that uses the near-term month, it’s value can get hurt by buying the contract and selling it when it comes down.
For example, if a fund needed to sell its October holding and buy the November holding. It would sell at 96.53 and have to buy at 96.82. The fund will either get fewer contracts because the one it is buying is more expensive than the one it is selling. Or it will need to come up with additional cash to buy the same number of barrels.  Both scenarios will impact the value of the fund in a negative fashion and over time, that 30 cents difference adds up and causes the fund to have some negative tracking against the commodity. This is why these are considered short term trading vehicles and not to be held for long periods of time.
Sometimes, a commodity is in “backwardation”. That is when the current contract price is more than the farther out months. Take Gasoline for example. Right now here are the per/gallon prices for the next few months:
Oct 2012:       3.0384
Nov 2012:      2.9148
Dec 2012:      2.8386
Jan 2013:       2.8090
Feb 2013:      2.8030
Mar 2013:      2.8124
When this happens, a fund can buy contracts for less than it sold them for and that means profits above and beyond the changes in commodity prices. If an investor knew what price a commodity bought it’s monthly contracts, he/she should be able to determine how the ETF was going to trade.
Now the big question…how do you know what price the fund bought the contracts for? For UGA, the US Gasoline Fund, that information is provided right on the fund’s site.
By going to their site you can see that they are long the Oct 2012 contract at 3.0196. With gasoline trading at 3.0384, for example, the fund not only gets the appreciation of the underlying commodity, but also has a favorable cost basis.
This explains why UGA, when compared to the actual RBOB Gasoline futures, is up so much. Those familiar with the fund know it will have a gain due to the backwardation. For now, the outperformance is warranted, but watch for contango to start slipping via the underlying commodity. When that happens, expect UGA to fall back in line with the spot gasoline prices.

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