Investing in exchange-traded products (ETPs) remains one of the simplest ways to gain direct exposure to the movement of oil prices, however, events this year culminating in an SEC probe into the world’s largest oil ETF, the $4.6bn United States Oil Fund (USO), could have a lasting impact on investor demand for these strategies.
What happened to oil ETPs during the coronavirus turmoil is well documented. When oil prices did the unthinkable and fell into negative territory for the first time in history, ETF issuers and index providers suddenly realised their strategies were at much greater risk than they first thought.
In order to prevent investor returns from being entirely wiped out, ETF issuers, such as USO’s manager, United States Commodity Funds (USCF), immediately rebalanced away from the risky front-month oil futures contracts and into later date months that were less likely to fall below $0 a barrel.
The negative effect this had, however, is when oil bounced from the historic lows, investors missed out on much of the upside as they were exposed to the less volatile contracts which do not mirror the spot price as closely.
As a result of actions taken during the extreme volatility, the Securities and Exchange Commission (SEC) has issued USO, USCF and CEO John Love with a Wells notice, which notifies the party of impending charges, something USO’s intend to “vigorously contest”.
The SEC probe did little to impact short-term demand, however, with investors piling $414m into USO in a single day last week, according to Bloomberg, the largest one-day inflow since April.
Europe’s largest oil ETP, the $1.6bn WisdomTree WTI Crude Oil ETP (CRUD), has not had the same interest since the issuer changed its investment strategy on 15 July to an equal-weighted basket of three WTI futures contracts instead of just the front-month contract.
Since making that decision, CRUD has seen $162m outflows, according to data from Morningstar, highlighting a potential lack of interest in the strategy’s new approach.
Furthermore, the last six months has highlighted a structural flaw within these strategies and the new approach will not offer investors what they are looking to be exposed to and that is the WTI spot price.
As one industry source said: “If the products and indices have always been flawed, it shows ETF issuers do not stress test the indices enough to ensure they can withstand troubled times.”
Meanwhile, many other oil ETPs have not been as nimble as CRUD and are still exposed to a series of effectively random months on the WTI futures curve.
As Raymond Backreedy, CIO at Sparrows Capital, said: “Ordinarily the ETF should be tracking a benchmark holding the underlying in those proportions, but now with the added leeway of different months, to overcome the structure issue, the fund manager has discretionary, so we are moving away from a rules-based, systematic and transparent approach to one that is active and discretionary.
“Therefore, no-one is now entirely sure what is being bought or sold for that matter.”
This leads back to the point that it is crucial investors do their due diligence and look under the hood of the strategy they are investing in especially in an area as volatile as oil.