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ETF's leak money April 2, 2011

An ETF (Exchange Traded Fund) is a stock (like a mutual fund) that lets ordinary investors invest in commodities and assets like oil and gold.

Without an ETF, it would be difficult to invest in the price of oil. You could invest in an oil company, like Exxon Mobile (XOM) or BP (BP), but the prices of these stocks only loosely correlate with the price of oil. You could theoretically rent out a tanker to physically store the oil, but only big firms like JP Morgan can afford to do this.

So instead you buy an ETF like OLO, whose daily price changes are designed to match the daily changes in oil as close as possible. If oil goes up by 5% one day, this ETF should go up by about 5%, too. They even have short ETFs (like SZO), where its price should go down by 5% if oil went up 5%.

The way these ETFs work is by buying and selling short-term oil futures, and "rolling" these contracts from month-to-month, buying new ones to replace expiring ones. They don't actually have to own any barrels of oil.

ETF's leak money

What most people don't realize is that this process leaks money. It takes money to run the ETF - buying and selling futures has its transaction costs, plus you have to pay guys in fancy suits to watch over the whole operation.

By "leaks money", I mean that the price of the ETF slowly goes down over time. It's like a boat with a small hole in it - the waves (oil prices) may bounce the boat up and down, but ultimately the boat will sink.

So how big is the hole? How fast does it leak money? It's hard to measure exactly, but here is some interesting data: the table below shows prices for OLO, SZO, and WTI crude futures, on 2 dates about a year apart:

DateWTI crude futuresOLO (long oil)SZO (short oil)
Jan 8, 2010 $83.25 $14.06 $46.15
Dec 31, 2010 $89.68* $14.00 $44.31
Change: +8% +0% -4%

[* Dec 30, 2010 price, no data available for Dec 31. Was $91.58 Jan 3, 2011] As you can see, the price of oil went up 8% over that time, yet OLO remained at the same price. (Now, there might be some intricacies I'm missing, in the way futures prices are calculated at the end of the day, or there might be other weird near-expiration effects happening.)

But there's another way to measure the leak: if there were no leak, the price of $100-of-OLO + $100-of-SZO should remain constant. That is, buying equally-weighted shares of each puts you in a combined neutral position where the price increase of one stock should cancel out the price decrease of the other. However, the combined $100-of-OLO + $100-of-SZO went down about 2% during that time. (I should really calculate this leakage on a month-to-month basis, and average over a number of years.)

Don't buy-and-hold ETFs

Some people believe that oil will run out in the next 20 or 30 years. And they might be right, but buying-and-holding an ETF like OLO isn't a good way to make money in the long term. During those 20 or 30 years, OLO is sinking by a few percent each year.

ETFs: the ultimate bookie

On a side note, I'd like to point out how awesome it must be for the ETF companies, like Power Shares (the guys who run OLO and SZO). You're basically just a middle-man between someone betting for the price of oil, and someone else betting against the price of oil. Effectively, the ETF company is just a bookie, and doesn't care which way the price of oil goes. There's very little risk, and they are happy to silently take 3% of your money each year.

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