There's no shortage of ups and downs in the markets lately, and the volatility isn't limited to stocks. Some other financial markets have seen even more turbulence, with the crude oil market in particular being a focal point for issues ranging from the coronavirus pandemic to geopolitical tensions between OPEC and Russia.
Supply gluts and demand disruptions led to plunging crude oil prices, and many investors hoped that by investing in the United States Oil Fund (USO -1.13%), they'd be able to benefit from a recovery in oil. What fund investors have gotten instead is a rude awakening of what can happen when a commodity-tracking ETF has to take drastic measures to ensure its own survival. Even as crude has rebounded, U.S. Oil Fund shares remain far below where they traded just a month ago.
What should have happened to U.S. Oil Fund
The idea of the United States Oil Fund is to track the movement of spot oil prices, specifically West Texas intermediate crude. To do so, the fund invests in futures contracts -- until recently, the futures contract that was set to expire somewhere between two and six weeks into the future.
On April 17, June crude oil futures traded at about $25 per barrel. On May 13, those same futures traded at the same $25 level. U.S. Oil Fund's methodology would've had the fund holding June futures between mid-April and mid-May, and so shareholders could've expected essentially no change in the fund's share price over that period.
What really happened instead
That sounds simple, and for the commodity-linked ETF, it's supposed to be that simple. But instead of holding its own, U.S. Oil Fund has lost almost 40% of its value over that four-week period -- and it'll take much bigger recovery in crude prices for investors to be able to get those losses back.
The disconnect comes from the changes in methodology that U.S. Oil Fund implemented during the past month. When the June futures contract was near its lows, the fund decided to move some of its oil exposure further into the future, buying contracts extending as far as mid-2021. Those later-month contracts hadn't seen the same volatility as the June contract, so they didn't rebound to nearly the same extent when spot oil prices recovered.
A new future for U.S. Oil Fund
A tracking error of 40% is problematic enough for U.S. Oil Fund. Although the fund admitted that it wouldn't be able to guarantee tracking spot crude because of its methodology changes, some shareholders nevertheless expected more participation in a rally if it came. The roughly 20% that U.S. Oil shares have recovered did little to lessen longer-term losses.
But the real issue for U.S. Oil Fund is that it's decided to make its investment strategy opaque to investors. Current holdings show futures contracts ranging from July 2020 to June 2021, with target weights that spread out the fund's exposure fairly equally over the next six months with a small 10% position for futures a year out. However, the fund has made it clear that changes to that strategy can come at any time as market conditions warrant.
ETF investors need to know what they're buying
If U.S. Oil Fund could decide on a strategy and stick with it, then investors would at least know the risks they face. A single-contract methodology would leave the fund vulnerable to catastrophic losses -- but it'd be a known vulnerability. Trying to take a flexible approach makes it impossible for fund investors to know whether what they're buying today will at all resemble what they own tomorrow or next week.
For energy investors looking to track the price of crude, USO has failed its shareholders. Only if the fund can find a strategy it can live with over the long run will it be able to start regaining the trust of its hard-hit investors.