What you need to know before investing in oil ETFs and volatility exchange-traded funds
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Many investors who invest in commodity and oil ETFs, such as United States Oil (USO), or VIX volatility ETFs have been surprised that these exchange-traded products failed to closely track the rise in the price of oil or the spike in stock market volatility. In many cases, these commodity and volatility ETFs and ETNs generated significant annualized losses.
For example, the United States Oil (USO) ETF has returned -21.0% annualized for the ten years ending May 31, 2020. For the five years ending May 31, 2020, the ProShares VIX Short-term Futures (VIXY) ETF returned -35.9% annualized, despite gaining over 100% year-to-date.
Before investing in commodity and volatility-linked exchange-traded products, investors should understand what drives their performance. Roll yield is a large contributor to commodity and VIX ETF performance.
Oil and Volatility ETF Performance Drivers
The four components that determine the returns of commodity and volatility ETFs are:
- The change in the spot price
- The roll yield
- The interest on cash held
- Fees and expenses
Spot Price Return
The spot price is the current market price for VIX, a barrel of oil, or any security. The spot price return is the change in the spot price from one period to the next.
There are many asset categories, including oil and VIX, where it is difficult or impossible to invest in the spot price. An individual cannot easily store oil in their basement like they can a gold coin. Consequently, investors, including ETFs, invest in oil and VIX using futures contracts.
A futures contract is an agreement to buy or sell a specific asset at a future date. ETFs that invest in commodity or VIX futures enter into and exit a series of futures contracts. When the futures contract is close to expiration, the ETF will exit it and enter into a new futures contract that expires a month or more in the future. This process is called rolling forward a futures contract or a roll forward.
USO and Negative Oil Prices
In the case of oil, if the USO ETF doesn’t exit the futures contract before it expires, then the ETF has to take delivery of oil and find somewhere to store it.
It truly was like watching … a full speed train wreck. But you couldn’t stop watching. – Rebecca Babin, managing director CIBC Private Wealth Management, describing when oil prices turned negative in April 2020.
In April 2020, USO and other investors were desperate to exit West Texas Intermediate Oil (WTI) futures contract because there was a glut of oil and not many places to store it. The clamor to exit the expiring WTI futures contract was so intense that investors paid money to exit the contract.
The spot price of oil is based on the futures contract that is closest to expiration. Consequently, when investors paid to exit the WTI oil contract, that effectively meant the spot price of oil was negative. At one point, the oil spot price fell to negative $37 per barrel.
Commodity and VIX ETFs enter and exit futures contracts to maintain exposure to the asset they are tracking. If the futures contract price increases during the holding period, then the futures contract holder earns a positive return. If the contract falls in price, then the futures holder has a negative return.
The holding period return for investing in a futures contract can differ from the spot price return over the same holding period. The roll yield is the difference between the futures price return and the spot price return. That is all roll yield is—the difference between two returns over the same time period.
There is no cash flow associated with roll yield, which is why the term is so confusing. Yields typically involve receiving cash flow in the form of interest or dividends.
Here is an example to better understand roll yield. Suppose an oil ETF like USO exits a futures contract that is about to expire for $30 a barrel and enters into a new contract that expires a month from now at $32 a barrel. Since the contract is about to expire, the $30 represents the current spot price because that is the price of the futures contract that is closest to expiration. The $32 price represents the market’s expectation of what the oil spot price will be in 30 days.
A month later, suppose the ETF exits the contract that is about to expire at $30 per barrel. Again since that contract is now the closest to expiration, $30 is also the spot price.
In this example, the spot price return was 0% since the spot price was $30 at the beginning of the period and $30 at the end. The ETF that held the futures contract lost $2 on the contract, entering at $32 and exiting at $30. That equates to a 6.25% loss.
The roll yield is the difference between the 0% spot price return and the -6.25% futures contract return. That means the roll yield was -6.25% in this example.
Negative and Positive Roll Yields
When future prices for oil and VIX are consistently higher than the current spot price, a situation known as a normal futures curve, then an ETF will consistently lose money as it rolls over future contracts if the spot price stays the same. This situation is known as a negative roll yield.
The only way an oil ETF will earn a positive return when there is a normal futures curve is if the spot price for oil when a futures contract expires is higher than the oil futures price at the time the ETF entered the contract.
Otherwise, if the spot price stays the same, when there is a normal futures curve, the ETF will always exit a futures contract at a lower price than it entered it, losing money, month after month.
An inverted futures curve is when futures prices are lower than the current spot price. In this situation, an ETF that invests in oil or VIX futures will have a positive roll yield as the ETF will earn a profit on the futures contract if the spot price doesn’t fall below the futures price the ETF paid when it entered the contract.
In other words, if the spot price stays the same, the ETF would still earn a profit because it entered into the futures contract at a price below the spot price. That means it will exit the futures contract at a higher price than it paid, earning a profit.
Other Commodity and VIX ETF Return Factors
While fluctuations in spot and futures prices are the primary drivers of commodity and VIX ETFs, there are two additional factors.
The first is the interest that the ETF earns on cash. Futures contracts are leveraged in that an investor can get a large amount of exposure to commodities and VIX without having to put up much capital. Consequently, commodity and VIX ETFs have large cash balances that they can safely invest to earn interest. That interest contributes to the ETFs’ returns.
Like all ETFs, commodity and VIX ETFs charge a management fee and incur other expenses that reduce investors’ overall return.
What Determines VIX and Commodity ETF Returns
- Change in spot price
- Roll yield
- Interest on cash
- Fees and exspenses
Why Invest In Commodity and VIX ETFs
Most of the time, the futures curves for VIX and commodities is normal in that futures prices are higher than the current spot price. That means ETFs that seek to benefit from an increase in commodity prices or a jump in the VIX index will have a performance drag due to the negative roll yield that results from a normal futures curve. Negative roll yield has been a large contributor to the long-term negative annualized return posted by these ETFs.
Individuals should only purchase a VIX or commodity ETF if they believe futures prices will be higher not only than the current spot price but also higher than the consensus view about the future price of VIX and commodities.
Futures prices are based on investor expectations. If the current spot price of oil is $30 and the oil futures for a contract that expires in one month is $32, then an investor will only earn a profit if the spot price 30 days from now is greater than $32.
The spot price when the contract expires needs to exceed the futures price at the time the contract was entered. That futures price represents what market participants expect oil prices to be. Investors in commodity and VIX ETFs will only make money if prices for commodities and VIX surprise to the upside.
Investors in commodity and VIX futures ETFs should consider whether they have any insight to suggest the consensus view about prices in the future are wrong. Because due to negative roll yield, the consensus of investors needs to be wrong for investors to earn a profit investing in commodity and VIX ETFs.
David Stein is the founder of the Money For the Rest of Us investment education platform. Since 2014, he has produced and hosted the Money For the Rest of Us investing podcast and led the Money for the Rest of Us Plus membership community. He is the author of Money for the Rest of Us: 10 Questions to Master Successful Investing, which was published by McGraw-Hill. Previously, David was an institutional investment advisor and asset manager. He was a managing partner at Fund Evaluation Group, LLC, a $70 billion investment advisory firm. At FEG, David served as Chief Investment Strategist and Chief Portfolio Strategist.