Understanding the future—not just the present—is very important to ETF returns. And this is where the two basic questions for investors get answered.

What is the timeline of the trade?

The real question here is, how many times does the ETF have to “roll” its futures contracts between now and that trade date?

Use oil as an example. Because the ETF issuers never want to physically own the oil, they must sell their futures contract before it expires, at which point they would need to take possession. So they sell it and buy a longer-dated futures contract — either the next month or several months out. This buying and selling of futures is called “rolling” it forward.

Are the futures contracts showing higher prices (in contango) or lower prices (backwardation)?

When the market is in steep contango or backwardation, that is to say when the futures market is very different than the spot price, indicating a big move in commodity prices, the ETFs get caught in a tight spot.

InvescoPowerShares’ Lake explains: “If you’re rolling into a contango market, an upward sloping curve, you will roll into a more expensive contract, and there will be a drag on performance.” (The PowerShares oil ETF symbol is DBO-NYSE.) “We use a more flexible rolling strategy, so we can reduce the impact of contango and increase the benefits of a backwardated futures market.”

In 2009, that drag was severe, as the spot price of oil rose almost 70%, and the futures market correctly anticipated that move, as there was a ladder of higher prices in the futures contracts. The problem: ETFs had to sell their lower-priced contracts that were nearly expired and buy the more expensive contracts dated farther out. And the more often they rolled, the greater divergence there was between spot prices moving and ETF prices moving.

That scenario caused many retail and professional investors, like Philip Treick, managing partner of Thermopolis Partners, to avoid going long the ETF sector.

“The contango futures curve forces an ETF manager to sell the current expiring contract low and buy the replacement contract higher — hardly a recipe for success,” says Treick, who manages two natural resource funds out of San Francisco and Jackson Hole, Wyoming.

“Institutional and individual investors bought these ETFs hand over fist assuming they were gaining exposure to a rising commodity price when actually, the roll was obliterating returns.”

In 2010, however, Hyland says it has been a different story.

“Year-to-date, the amount of contango in the front-month oil contract for WTI has been eroding a bit more than 1% from the return. If someone is looking at this investment as a three- or four-week play, how much do they care about contango or backwardation? It’s not that you won’t feel it, but in the bigger picture, how much does it really matter? In any single day the spot oil price often moves 1% to 1.5%.

“But if you’re looking at 12 months, then it’s a bigger factor.”

In other words, the trade timeline is greatly affected by the roll.

Hyland’s funds continue to roll their contracts forward monthly, to the nearest contract. While this is simple, it also increases any distortions from contango or backwardation. Other ETFs, like PowerShares’ DBO, use a more flexible strategy that can roll once or many times a year.

Morningstar ETF analyst Abraham Bailin says the ETF issuers are evolving their products to meet the market’s concerns about the roll.

“Futures-based funds are using dynamic strategies, like USCI, The United States Commodity Index Fund, for instance. They can choose contracts out as far as 12 or 13 months, that can maximize gains or minimize losses posed by the implied roll yield. Some of these dynamic methodologies are getting very crafty.”

USCI trades all commodities, not just energy, and will buy futures in backwardation, where it can sell higher-priced, near-term futures contracts and buy lower-priced contracts farther out in time, pocketing the difference.

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Tax Issues with ETFs

A secondary characteristic of ETFs that few investors pay attention to is their tax treatment, which depends on the funds’ structure. The Wall Street Journal reported in April of this year that ETF holders could get taxed at 23% — higher than the 15% rate investors are used to paying on stocks and mutual funds in the U.S. — on gains they haven’t taken yet under I.R.S. rules, which state that open positions in futures contracts are to be “marked to market” at year-end.

“We find it (futures-based commodity funds) irritating to customers at tax time,” says Richard Shaw of QVM Group, South Glastonbury, Connecticut. He buys a lot of ETFs for his clients, and writes about them as well—but he doesn’t buy energy ETFs, because of the roll issue, and “they are taxed in complicated ways. A CPA has to take more time.”

There are other issues with energy ETFs as well. Sometimes the popularity of an ETF will cause it to trade above its net asset value if the issuer is not granted permission to increase the number of units.

Professional traders claim they can “front” the roll at the expense of other ETF shareholders, by buying large amounts of the same futures contract that the ETF does — just before the ETF buys it. They then sell into the ETF buying.

There are also a growing number of levered commodity ETFs, which try to give investors two or three times leverage to the moves in commodity prices or commodity indexes or commodity equities. These often take the form of exchange-traded notes, or ETNs, which have completely different issues for investors and taxation methods.

But for ETFs, understanding how the futures market works, and how the ETFs play that market, are two sides of the same coin that investors must have comfortably in their pocket before spending a dime on the funds.

People invest in ETFs like they would a stock, but because of the way they are structured, they act more like a bond. Like a bond-maturity date, the futures market tells investors where their investment in a futures- based ETF is likely headed, and they need to determine which ETF product gets them there the most profitably.

– Keith

Follow this link for Part 1 of my report, ETF Investing in the Oil & Gas Market

* Article originally published in Oil & Gas Investor in December 2010