ETFs 101 – Part III

In PART III, we will briefly look at some types of ETFs that require some special attention, namely Leveraged ETFs and ETFs that attempt to track the price of a commodity.

Leveraged ETFs – Proceed With Caution

Leveraged ETFs gives you a 2 (or more) times the daily return.  For example, if you own an ETF that gives you a 2x leverage return, if the corresponding asset that the ETF is tracking goes up 10%, the ETF you own will be up 20% that day.

Before getting into further details, if there is one thing you can take away from this section, it should be this:  DO NOT hold these ETFs for long periods of time.  Use them just as shorter term trading vehicles.

So what’s the problem?  Well, these ETFs re-balance your exposure to the asset daily at the end of the day which either increases your exposure if the price has moved in your favor, or decreases it if it has gone against.  As long as the price is trending in your favor, things will be fine.  If the price of the asset fluctuates back and forth, things won’t work out so well.  Even if you end up being right about the direction of the price movement, you could lose money!  Huh?  Well, Horizons does a good job explaining the math of these ETFs in their simplified example in the document here if you need a an example.

In short, the trend is your friend, volatility is your enemy!

Commodity ETFs

Most ETFs that track commodity (oil, gas, gold, etc) prices actually use futures contracts to gain the exposure to the commodity.  A futures contract is a financial contract which obligates the buyer of the contract to buy the asset at a specified future date, at a specified future price.  The returns on futures contracts are made of 3 components; the spot return, the roll return, and the collateral return. It doesn’t simply depend on the price of the commodity or asset itself.

The takeaway here is that the ETFs won’t track the price of the commodity exactly because the returns on futures contracts rely on more than one factor to calculate the total return.

I won’t attempt to explain the ins and outs of futures contracts as I only know the very basic theory.  If you are a DIY investor and plan to use these ETFs, at the very least, you should understand what contango and backwardation mean in relation to futures curves and see how it plays into the return of the commodity ETFs.

Let’s walk through a basic example and try to explain contango.  Since buying a futures contract involves locking in prices for something out in the future, the price at each future date will vary.  Plotting prices versus the dates on a graph gives you the shape of the futures curve.  When prices farther out in the future are higher than nearer term prices, the curve is said to be in contango.  Figure 1 below shows a hypothetical futures curve in contango.

Figure 1

Let’s assume the prices shown in figure 1 represents the price of a barrel of oil.  Suppose we want to secure the price at which we buy a barrel of oil 1 month from now.  We decide to enter into a 1-month futures contract that obligates us to pay $110, in return, we would get a barrel of oil in a month’s time.  Note that a barrel of oil today is trading at $100.

Now, assume a month has elapsed.  Let’s walk through a couple of scenarios:

Scenario 1:  Price of oil after 1 month is still at $100

Since we entered into the contract, we have to pay $110 for the oil.  We effectively ‘lost’ $10 even though the price of oil didn’t change.  Had we not entered into a contract, we simply could have bought the oil for $100.

Under this scenario, even though the price of oil didn’t change, if we had an ETF that used futures contracts to track the price of oil, it would show a loss.  This is somewhat simplified, but hopefully you get the idea

Scenario 2:  Price of oil after 1 month is at $110

Since our contract price and current market price is identical, we don’t gain any advantage, despite the price of oil rising $10.

Under this scenario, even though the price of oil went up 10%, if we had an ETF that used futures contracts to track the price of oil, it would not show any gains.

These above examples show the effect of contango.  Backwardation is just the opposite, where future dated prices are lower than current prices.

This is the end of the 3 part series on the introduction to ETFs!

If you would like to watch video presentations on basics of ETFs, you can view the presentations by iShares and Index Universe.


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