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Raising the Red Flags on Commodity ETF’s

The July 26-August 1, 2010 print edition of  Business Week magazine put out a brilliant piece entitled “Amber Waves of Pain”  detailing how retail investors are getting fleeced when playing the agricultural and commodities ETF’s.

The unwary are getting shredded by the contango, whereby far month futures contracts are trading at enormous premiums to the front month. An entire sub industry of hedge funds has arisen to take advantage of this spread, at the expense of the ETF investor.

Commodity ETF’s tend to own front month futures with huge premiums which quickly disappear, leading to a large underperformance relative to the underlying.

I have been highlighting these risk for the past year, and have done my utmost to steer readers away from the worst offenders.

The oil ETF (USO), has been similarly victimized, with Morgan Stanley now chartering tankers to take delivery of crude than Chevron.

The problem persists in the agricultural commodities of corn (CORN), wheat (WEAT), and soybeans (SOYB), although to a much lesser extent.

Hedge funds in particular game the published “roll dates” when ETF’s shift positions from one month to the next. The only way to avoid this haircut is to trade short term and avoid the roll, deal directly in the futures, or only trade the physical commodity with an expectation to take delivery.

I have several friends who warehouse copper, and a London hedge fund recently accepted a huge quantity of cocoa.

Business Week, which was taken over by Bloomberg only a few months ago, is infamous in the investment world as the publication that ran its notorious “Death of Equities” cover in 1982. That was right at the absolute bottom of a two decade bear market, when the Dow was trading at the 600 handle. But they do raise some appropriate red flags here.

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Courtesy: Mad Hedge Fund Trader


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