BOSTON – The hottest funds over the last three years have been those focused on energy as investors have developed a nearly insatiable appetite for oil. So when the world's first pure-play oil fund was introduced on the American Stock Exchange in April, it attracted a lot of interest from investors looking to juice up their portfolio.
But instead of finding black gold in the United States Oil Fund (USO) , investors have struck a Stupid Investment of the Week.
Stupid Investment of the Week showcases the traits and characteristics that make a security less than ideal for the average investor in the hope that spotlighting danger in one situation will make it easier to root out elsewhere. While obviously not a purchase recommendation, the column is not intended as an automatic sell signal.
It would be easy to look at declining oil prices over the last month as reason enough to bail out on a new fund designed to track movements in crude prices. In that time, USO shares are off more than 15 percent, ranking dead last in the natural-resource category, as tracked by research firm Morningstar Inc.
But the problem with United States Oil has less to do with the investment logic of making a play on oil this late in the cycle than it does with the way this unusual fund is built. There is little doubt that the average investor thinking this is a new and different way to buy an energy fund doesn't have the whole picture.
United States Oil Fund is an exchange-traded fund. Ordinarily, you can sum that up by saying that an ETF tracks a benchmark index, like a standard index fund, but trades like a stock. But USO invests in commodities, specifically short-term futures contracts on West Texas Intermediate Light Sweet Crude.
Investing in commodities, however, is not only a unique strategy among ETFs but changes the way USO is regulated and taxed.
The typical mutual fund and ETF falls under the Investment Company Act of 1940, but the commodity investments in the USO force it under the more-restrictive Investment Company Act of 1933. One crucial change as a result is just how much management can say about their investment.
The typical mutual fund gives some guidance as to who it is right for, how it works and more. United States Oil managers can't do much more than point to their prospectus, a mind-numbing 157 pages filled with language that could confuse commodities traders and accountants alike.
And the bean counters should be involved before a typical consumer buys the fund because USO, from a tax standpoint, is a limited partnership. That means that in any year where the fund realizes any sort of gain, shareholders will get a form K-1 (instead of the 1099 that applies to most investments) and will have to pay taxes on those gains. Those taxes are due even if management holds true to its plan, and makes no distribution of the money; in any year where the fund does well, a shareholder who fails to plan for the tax consequences could be in for a nightmare come filing time.
Confusion for Consumers
Beyond those underpinnings, investors seem to be a bit confused as to what the fund is supposed to do.
United States Oil is trying to have its daily movements match those of light sweet crude futures contracts. Co-manager Nicholas Gerber acknowledges that many investors seem to think this means that if the price of oil goes up a penny the fund will do the same thing when the truth is that the movement is based on percentages; a 1 percent loss in light sweet crude futures contracts would mean a 1 percent drop in the USO.
Gerber says he'd be happy to ease any confusion shareholders have, but the 1933 act pretty much forces him to tell those investors to root it out of the prospectus.
Depending on market conditions, some energy watchers would suggest that West Texas Intermediate light sweet is not the best proxy for the entire energy industry. An ordinary sector mutual fund, which would invest in a basket of natural-resources stocks, would better reflect the big picture.
By being more diversified, even if it focuses on the energy business, a traditional energy-sector fund would be much less volatile and better prepared to handle a downturn. In the last three months, for example, the USO is off more than 11 percent while the average natural-resources fund is just slightly above break even.
And while ETFs are being sliced pretty thin to cover niche businesses, critics suggest that issues like USO are too narrow; investors who think they are getting diversification at a low price wind up only getting the low costs, without spreading their assets around.
"The USO sure makes people think they know what they're getting, which is an instrument that lets you play on the price of crude oil," says Jim Lowell, editor of the Forbes ETF Advisor newsletter. "That is where most investors stop thinking about it and start investing in it. ... That's not quite how it works, and if you can't understand what you're investing in, good luck if you actually buy it."
Says Gerber: "We have a target market, we know who we are going for, and we also know who the fund is not meant for. ... Because we cannot say what the fund is good for and who it is right for, it is clear that some people who shouldn't be in the fund probably own it."
Clearly, the investors who don't belong in the fund are the average ones, those still hanging on to a volatile oil play after seeing the market bludgeoned.
"A bet on a single commodity is gambling, not investing," says Herb Morgan, chief investment officer at Efficient Markets Advisors in San Diego. "It's a case of grasping on to the ETF fad in an asset class that was experiencing investor euphoria. Now the euphoria is over and this is so focused that investors could get really hurt. For a prudent investor, this just doesn't belong in the portfolio."
Copyright (c) 2006 MarketWatch, Inc.