Arbitrage with Poorly Performing Commodity ETFs
Joshua is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The perils of investing in commodity ETFs which hold their assets in futures are well known. Due to the cost of rolling front month futures based commodity ETFs like United States Natural Gas Fund, LP (NYSEMKT: UNG) and United States 12 Month Natural Gas Fund (NYSEMKT: UNL) post serious tracking errors over time frames of a couple years. Yet these tracking errors can possibly be used to do a type of arbitrage. Over the short run the volatility posted by commodity ETFs and companies and funds closely related to natural gas like First Trust ISE-Revere Natural Gas (NYSEMKT: FCG) EnCana Corp (NYSE: ECA).
The below chart shows the spot price of natural relative to various securities over the past couple years. While FCG, an ETF which invests in companies in the natural gas market has gone sideways its' returns are close to the overall change in the spot price over this time period. The fund is fairly well diversified but the wide variety of its holdings means that it is exposed to more than the spot price. Some of its current investments like Talisman Energy Inc. are doing more than just exploration. The changing price of natural gas has only a limited effect on their stock price. Reserves are closely related to the current natural gas price but income from transportation services are more related to volume.
Like the oil fields in Saudi Arabia which are continually facing declining production volumes, futures based commodity ETFs continually pay the price to rolling the front month contract. The UNL and UNG have not posted exactly the same returns as the specific derivatives used differ for each fund. UNL varies their contracts out over a 12 month period which means they a lower rollover cost. This is show in the chart below as they posted a 64% loss while UNG posted a 78% loss for the same time period.
The above chart shows how money could be made by taking a long position via futures or through First Trust ISE Revere Natural Gas Index and simultaneously take a short position in UNG or UNL. The first quarter in 2010 shows that the natural gas spot price and FCG are not highly correlated in the short run. Over the long run the two become more correlated and futures ETFs post greater and greater losses.
Theoretically one could substitute the long position for a position in an individual natural gas related companies but that appears rather risky. The above chart shows how Encana has faced an extremely steep decline over the past couple years. With debts, lower revenues on existing fields, and negative EPS investors are definitely hesitant. With such a great amount of volatility it would be hard to run an arbitrage set up with such a stock and still make money after costs.
Inefficiencies in the market do exist. Close ended funds commonly trade at discounts or premiums to their net asset value. Class A and B shares with similar or equal income benefits can trade far outside their acceptable spread due to other people shorting just one of the share classes or a host of other possibilities. An advantage of being a small investor is that one does not need to stick to large caps to make a sizable investment. The hidden cost of rolling commodity ETFs is one such situation where the individual retail investor can benefit.
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