In April, many investors were caught by surprise on the price movement of the United States Oil Fund (“USO”), which is an exchange-traded fund (“ETF”) that seeks to track the West Texas Intermediate (“WTI”) crude oil. A myriad of investors flooded this ETF as a means to gain exposure to oil, in hopes that the price of oil would rebound. As a result, the USO has seen inflows of close to US$2 billion since the beginning of the year.
Astonishingly on 20 April 2020, the May WTI Crude Oil futures plunged, and the contract price went into negative territory, which no one ever thought was possible prior to this. The significant drop in price took place amidst the Covid-19 pandemic, as the lack of demand coupled with an oversupply issue saw the world ran out of storage space for crude oil. In other words, oil producers or rather futures holder were willing to pay for someone to take the oil of their hands.
So, how does the negative crude oil futures impact USO?
We will need to drill down to how USO works and look into its asset allocation policy. First of all, many investors probably did not realise that USO tracks the price of futures rather than the price of oil. Futures contract has an expiry, and there is a constant need for USO to sell its front-month holdings to rollover its position in futures contracts to the following month, in which we call the rollover process.
During the rollover process, USO may be faced with the following possibilities:
- Contango – when contract price is lower for the nearer expiry as compared to the price of the futures contract of a longer expiration.
- Backwardation – when contract price is higher for the nearer expiry as compared to the price of the futures contract of a longer expiration
USO’s investment strategy mandates it to take on an increasingly dominant position in the front-month WTI futures contract. As the fund receives inflows from investors, they are obliged to take on more positions in the front-month WTI futures contract. USO was badly hit nearer to the expiry date of the May futures contract when investors were seen to be dumping the futures contracts as they do not intend to take delivery of crude oil. This sent prices downwards and the value of USO eroded along with the futures contracts. This caused USO to see a loss of 42.7% from the period of 1 April to 22 April 2020, while the WTI oil price loss 32.2% (Source: Bloomberg).
While USO gives you good exposure to crude oil, and it may make sense for any rational investor to bet on crude oil’s recovery, it is important to remain mindful of the lessons which we can draw upon from this recent event.
Lesson 1: Understanding the structure of the ETF
More often than not, we tend to take things for granted. We assume that an ETF will just invest in the underlying assets that it intends to track. Don’t fall into this trap. As boring as it sounds, you should always read the prospectus or fact sheets to understand the investment strategy, asset allocation and risks of an ETF before investing. Futures-based ETFs are not as straightforward as it seems.
Lesson 2: The price of futures contracts may deviate significantly from the underlying asset’s price
This is important to note especially if you are investing in a futures-based ETF. These ETFs track the prices of the futures contracts rather than the underlying itself. It is possible that the ETF may underperform the underlying’s return by a significant value.
Lesson 3: The importance of the creation and redemption process for an ETF
When the demand for a specific ETF increases, the Participating Dealers can create more units for the ETF to be traded on the secondary market in order to match the demand and ensure that the ETF is traded in line with the Net Asset Value (NAV).
What will happen when an ETF is not able to create more units when demand surge? Well, the bidding can now be well over the NAV of the ETF, detaching from its fair value.
On 21st April 2020, USO had to freeze the creation of new units. The price was then freely traded in the market, and a day after the freeze, USO was traded at a 36.4% premium to its NAV. An investor should always note that once things normalise, where creation can continue to take place, an ETF will most often than not, return to trading back at its NAV.
As tedious as it may sound, an investor should always take time to learn about the investment products that they intend to invest. By doing a thorough study, you can avoid taking unnecessary risks, if you are uncomfortable with the risks of the product. Most ETF issuers have tons of learning materials, articles and videos that you can go through to learn about ETFs. If you cannot locate answers to your questions on ETFs, and are keen to learn more, have a chat with us!
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