Index or passive investing in stocks has evolved to the point that an S&P 500 index fund will generally earn you a return that is very close to the index return. How does that work with commodity funds? At least, in the case of the Natural Gas ETF (UNG), the fund has deviated from natural gas prices quite a bit.
Source: Bespoke Invest
UNG makes it clear that it is not investing in natural gas itself. However, it does seek to track natural gas price movements. From its website, we glean this information on UNG’s investment objective and portfolio holdings:
The United States Natural Gas Fund LP (UNG) is an exchange traded security that is designed to track in percentage terms the movements of natural gas prices…
…The investment objective of UNG is for the changes in percentage terms of the unit’s net asset value to reflect the changes in percentage terms of the price of natural gas delivered at the Henry Hub, Louisiana, as measured by the changes in the price of the futures contract on natural gas traded on the New York Mercantile Exchange…
…The portfolio will consist of listed natural gas contracts and other natural gas-related futures, forwards, and swap contracts…
Investors in UNG probably thought they would benefit when natural gas prices went up, but it has not worked that way recently. I suspect this is due to the fact that futures contracts that are further out — say three or six months — have a higher spot price than the near month contracts. Due to UNG’s policy of rolling the near month contract into the next month, it is probably losing value each time it rolls into the next contract.
In mutual funds or ETFs that invest through futures contracts on a given commodity, there are a number of risks. The obvious one is that the underlying commodity may move in a direction you did not anticipate. That’s unfortunate, but most investors are no doubt prepared for that.
The hidden risk of commodities
Less well understood is the fact that spot prices for a given commodity and futures contracts for that commodity may not track well and may have very different price trends. An additional factor that may lead to tracking error is the inherent leverage in futures contracts themselves. From these factors, big tracking errors can ensue.
See also:
INFLATION: Can you protect your portfolio?
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Of value might be to add UNG’s NAV to the chart. You’ll see the NAV more closely aligns with NG prices. Part of the recent non-performance of UNG vs. NG is due to a diminishing premium in the ETF.
Good point David. Although from the perspective of someone who bought in during the time it was at a premium that is small comfort I suppose. Might be a good topic for a post. Should you buy an ETF or closed end fund at a premium?
these etfs are scams to steal the contango. Long the spot short the etf.
Dear Mister Brouwer,
I thank you for this meaningfull chart. But shouldn’t we ask it at the fund manager?
I hope he has an explanation for this discrepancy.
Sincerely,
René Eeckhout
Kurt,
Yes, I’m sure there were many uninformed investors that hopped on the “NG has bottomed” bandwagon over the summer, and bought UNG at a huge premium. Regardless, when a fund claims that it tries to track an index, it’s speaking about its NAV. The fund has relatively little control over the market price of the ETF. Premiums and discounts will be created due to over-exhuberance in either direction.
Even if you plot UNG’s NAV vs NG, I think you’ll still find there is some erosion of capital as you mentioned, just not nearly to the extent the above chart shows.
As for buying stocks with premiums/discounts? Personally, I only consider ETFs that are flat or trading at a discount. Likewise, I sell when the crowds get a little too crazy and premiums exceed say 5-7%. If I’m still gung ho on the ETF (and after considering tax implications), I may re-enter if the ETF trades back at a discount.
Nothing like buying assets at 80-90 cents on the dollar.
The only exception I make to this rule is for high quality income producing ETFS (and compared with my investment time horizon, and personal view of the future of interest rates)
David–Your points on ETFs premiums (premia?) are spot on. I think your investment philosophy is very good.
Kurt Brouwer is a fee-only financial advisor with three decades of experience. He is the chairman and co-founder of Brouwer & Janachowski, LLC. Kurt has written books, articles and hundreds of blog posts on mutual funds, ETFs and other investment topics. E-mail: kurt.brouwer *at* gmail.com.
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