| Future based commodities ETFs, such as the | | | | funds sell oil at say, $75, and buy the next month |
| United States Oil Fund, L.P. (USO on NYSE) have | | | | at $80, they take a loss of $5 per contract. Or |
| taken off in popularity around the world. These | | | | about 7% of fund value. Now the differences are |
| can be attractive investments for a variety of | | | | not usually that great between months, but it |
| individuals and institutions, however, they are not | | | | illustrates the point. |
| without risk. | | | | Additional leverage is also sometimes applied in |
| Perhaps first it's best to differentiate between a | | | | futures based funds. This is where the fund |
| futures based and an equities based fund. A | | | | manager uses leverage or margin to buy more |
| futures based fund buys commodities futures, a | | | | futures than what they could buy with the cash |
| type of derivative contract. An equities based | | | | they have. Often, these funds will buy twice as |
| fund buys equity securities in companies related | | | | many contracts as they could do using only cash. |
| to the commodity that you attempting to invest | | | | This doubles your risk and reward. If the |
| in. A futures based oil commodity fund may | | | | commodity goes up, you will earn two times the |
| invest in NYMEX Crude Futures, whereas an | | | | increase. If the commodity goes down, you will |
| equities fund will invest in oil companies such as | | | | lose twice as much as the decline. |
| Exxon Mobile. | | | | The alternative to future based commodity funds |
| The biggest risk of future based funds is certainly | | | | is equity based commodity funds. These are not |
| that the underlying commodity will decrease in | | | | without risk either. While a pool of equities will |
| value. For an oil commodity fund, if the value of oil | | | | generally perform in line with the rise or fall in the |
| goes down, the futures price goes down and | | | | underlying commodity, sometimes temporary |
| your investment goes down. | | | | differences occur. This can be due to bad (or |
| But there is another risk that is often | | | | good) news about a firm, currency differences if |
| misunderstood or not even considered. That risk | | | | equities are held cross-border and a number of |
| is roll-yield risk. Futures contracts have expiry | | | | other factors. This means if you are holding a |
| dates, where the firm holding the contract must | | | | fund during a day trade, you may be left with |
| take delivery of the underlying commodity (in the | | | | performance that does not correlate well with the |
| case of a bullish fund). Since your oil fund doesn't | | | | underlying commodity. |
| want millions of barrels of oil in their Manhattan | | | | Equity based funds can be leveraged as well, |
| office, they sell their futures shortly before the | | | | though this is more rare. |
| expiry date. Then they need to purchase the | | | | From the above information, one can see that |
| next month's future contract in order to maintain | | | | futures funds can be used to for very short, day |
| their interest in oil. | | | | trading type activities and equity funds can be |
| The issue here is that the majority of | | | | held over the long term. Using funds in this way |
| commodities markets are currently in "Contango." | | | | will get you your desired exposure without |
| This means that the next month's future price is | | | | unwanted risks! |
| higher than the current month's price. As these | | | | |