Lesson Learned Looking Back

The year is close to an end and both main street and Wall Street are quiet.  The holiday time tranquility is a good time to reflect on the past year.  Heading into 2016, my highest conviction investment ideas were the Russian stock market, silver, and oil.   Though the year’s not quite over, it looks like all three will register double-digit gains in 2016.

Silver prices climbed more than 45% by mid-year, then gave back about 30% in the second half,  but should still be good for about 15%.  The Russian stock market climbed more than 45%, but the home run was oil prices — up around 80% year to date!  Not bad in a year where the global stock market (as measured by ACWI) only returned about 8%.

I’m sharing this not to pat myself on the back, but to share an important lesson learned.  These investment ideas represented the main positions in our Macro Value strategy portfolio.  And while the strategy captured the returns on Russia and silver, it was unable to fully participate in oil’s runaway returns. This was due to problems I’ve written about before. Some commodities are difficult to gain exposure to as investments and oil is a perfect example.

The publicly traded financial products designed to provide oil exposure actually do a terrible job of tracking spot prices (or current prices) over time. This is because the products typically invest in futures contracts that track expected oil prices. The difference between spot and futures prices (under normal conditions) is known as “contango” (when future prices are higher than spot prices). Long story short, the products basically buy high, sell low, and suffer from time decay as they roll contracts.

A perfect example is provided by the returns on two of the most popular oil-based financial products, iPath S&P GSCI Crude Oil ETN (OIL) and the United States Oil Fund LP (USO).  These two products returned about 2% and 7% year to date, respectively.  The substantial difference from the 80% gain in spot prices is due to the effects of negative roll yield in contango. In reality, the only way to get pure exposure to spot oil prices is to buy and hold physical barrels of crude oil. That’s obviously not practical for most investors, not even the exchange-traded product sponsors.

As a result, these products are just ill-suited for tracking oil prices over time and are better used for trading short-term swings.  Having done the research I was aware of the issues and avoided these products, but still found myself having to choose from imperfect substitutes for oil exposure.  In the end, we managed to capture a 15% return on our chosen oil proxy (oil & gas infrastructure-centric MLPs), but it was still a far cry from the 80% advance in spot oil prices.