The Weekly Walk of Shame: Oil ETFs

Motley Fool General Manager Randy Coon stopped by my desk last week and asked me what I was buying. After an extended answer that wasn't terribly intelligent, I replied in kind, and asked my boss's boss's boss what he was up to. He said:

"Not a whole lot, other than getting completely screwed by the USO."

More than one year ago, Randy looked at $40 oil and called its bluff. Rather than building a 50,000-gallon storage depot in his backyard (which, in retrospect, might have been a better idea), Randy instead chose to make an investment in an oil ETF that implicitly promised to track oil prices.

The problem is that Randy has gotten completely screwed. While oil roughly doubled in the ensuing months, Randy is up just a few measly percentage points on his investment in the United States Oil Fund (NYSE: USO) -- a truly disgraceful performance. The interesting part is that this problem is not reserved to this one lousy fund. In fact, the problem spans the entire industry of oil ETFs. The problem is this week's Walk of Shame.

A failure to deliver
As much as I like to rip on Wall Street, financiers tend to do a pretty good job of giving you exactly what you ask for -- if only on an extremely literal level. At Goldman Sachs (NYSE: GS), for example, if you ask for a mortgage security that yields 8%, the company will find one for you. The firm might neglect to mention that it's a terrible piece of crap. But, if all you asked for was big yield, then Goldman has technically fulfilled its end of the deal -- at least, so it says.

In this case, however, investors think they have asked for something relatively unambiguous (to track the price of oil), yet the companies that marketed these supposedly straightforward services have very clearly not held up their end of the bargain. They've failed on one of two levels, or perhaps on both. They failed to properly communicate that these ETFs are not, in fact, designed to track oil, or they failed to mention that they actually can't track oil on any kind of consistent basis. Either way, they've failed. Just examine the numbers.

Extraordinary underperformance
I've taken a close look at the performance of two ETFs and one ETN that are all implicitly designed to mirror the performance of oil. They include the U.S. Oil Fund, the PowerShares DB Oil Fund (NYSE: DBO), and the iPath S&P GSCI Oil Total Return Index (NYSE: OIL). I plotted out the relative returns of each of these entities against the performance of oil futures traded on the NYMEX (WTI), and I paid specific attention to the time period since oil crashed in December 2008. Here's what I found:

The graph is telling. As you can see, oil (found in blue) has indeed spiked since it bottomed out in early 2009. Randy was smart enough to know that it would. What he didn't expect, though, was that while real oil returned nearly 90%, his ETF would be up a pathetic 18%. As a matter of fact, all three funds have been grossly inadequate.

Shockingly, the only fund that comes closest is not actually an oil ETF at all. It's the SPDR S&P Oil & Gas Equipment & Services ETF (NYSE: XES) -- which I coincidentally bought. It includes big service players like Halliburton (NYSE: HAL) and others.

How much error is too much error?
Tracking error is a well-documented phenomenon playing a small role here. For a variety of reasons, ETFs, especially hard-asset ones, have difficulty keeping pace with their respective benchmarks -- which is fine. A point lost here or there is totally legitimate when it comes to emulating an index with no obvious way to mimic. This is probably why firms assign specific benchmarks that are not the precise closing price of oil, but rather something very close (the Goldman-Sachs Crude Oil Index, for example). But let's be reasonable about this. When you're off by almost an entire order of magnitude in performance, you might want to reassess your whole operation. Whatever these things are, they're clearly not effective plays on oil.

What about the money?
There's another fascinating part of this equation: the money. At the exact same time that these funds were lobbing up airballs against their implied benchmarks, the firms that ran these funds were collecting fees -- a lot of them. How much are we talking?

All data from Yahoo! Finance, except for the OIL ETN, which is from prospectus and assumes all notes are bought and held.

Should investors really be charged fees in the face for this kind of performance? I don't know. But I do know that if I asked my auto-mechanic to fix my tires and he replaced the steering column, I wouldn't give him the time of day.

If this were the real world, and not Wall Street, these firms would be making investors whole for the absolutely terrible performance of their products. At the minimum, they would return the management fees they've been collecting.

The Foolish bottom line
Perhaps this is just another case of Wall Street firms being exceptionally technical when it comes to the delivery of a product. We didn't say we were going to give you oil, per se; we said we'd give you an index that was meant to track oil. Sure. Or, perhaps, this is a case where companies have been, in fact, completely misleading about what they are really selling. Clearly, these are not 1:1 oil ETFs.

Either way, now you know. In the future, regardless of what you might see in advertisements, don't expect these ETFs to come remotely close to tracking the price of oil. Caveat Emptor.