THE UNITED STATES OIL FUND MYSTERY, REVIVED / THE FINANCIAL TIMES

The United States Oil Fund mystery, revived

By: Izabella Kaminska


© Tanawat Pontchour/Dreamstime



What has happened before will happen again (as someone on a sci-fi TV show once said).

In 2008/9 the USO ETF (United States Oil Fund) roiled the oil market when its assets under management mushroomed in size in response to apparently epic inflows from passive long investors.

The issue at hand was the fund’s obligation to invest in front month WTI contracts which — under its investment mandate — it was charged with rolling over in a predictable manner every month.

Rolling contracts in such a way exposes fund investors to two possible scenarios: 1) disproportional outperformance because the market is discounting the future versus the front-month (a structure known as a backwardation), meaning it becomes cheaper to maintain the same position over time which leads to gains on a per ETF unit basis 2) disproportional underperformance because the market is pricing the future in at a premium relative to the front-month (known as a contango), meaning it becomes more costly to maintain positions over time which leads to losses on a per ETF unit basis.

As the fund’s open derivative positions began to dominate front-month open interest in what was then a contango — and thus loss-inducing — market, the rolls became game-able. The wider market soon realised that if it too piled into the contracts ahead of the fund it could profit at its expense by ensuring it would cost the USO ever more to rollover its positions.

In turn this front-running exacerbated the contango, which increased the profitability of buying physical oil and putting it into storage while selling it simultaneously for a guaranteed profit at some point in the future.

Much debate was had on the topic of whether index funds — due to their passive nature — had the capacity to distort the underlying physical market as a result. To calm concerns, regulators soon introduced stricter position limits on derivative contracts to limit the possible impact of outsized positions on physical markets.

From the get-go the fund’s transparency was a key part of the problem. It was just too easily anticipated in the market.

And yet, what people really wanted to know was how come — given the overall bearish sentiment at the time — retail investors were so keen to pile into the oil market so intensively at this point? How come they had so much more risk appetite for bottom-hunting than managed money investors or other institutions?

Over the course of the next few months and years, FT Alphaville discovered that attributing that sudden growth of the fund solely to bullish retail investors was probably too simplistic.

Things happening again

In March 2020, the USO fund once again began to mushroom in size as it did back in 2008/9 and again when oil collapsed in 2014. And, once again, people are asking how come ETF investors are so bullish when everyone else is still seemingly so bearish? Why do they have so much risk appetite for bottom hunting when no one else does?

The growth of the fund this time round is no less impressive. Since the end of January 2020 assets under management have grown from approximately $2bn to $4.2bn, with the fund occupying an increasingly dominant share of open interest in the front month contracts.

To expand on some of the less appreciated factors at play we thought we would wrap our insights into a 30 min screen cast:


https://youtu.be/67YNg6CoOBo

The video looks at some of the arbitrage mechanisms in play, how authorised participants and market makers operate in the market, and how in some cases shorting demand can actually perversely encourage fund growth (as long as someone is prepared to finance the offsetting position).

An ETF’s AUM growth/ contraction is thus not solely determined by buying interest alone, but whether that “buying” is overpriced or underpriced relative to the indicative value of the underlying holdings of the fund.

We explain how ETF premiums over and above the indicative net asset value of the fund drive creations (and thus fund growth). But also how these premiums manifest both when there is excessive demand for an ETF relative to its underlying but equally when there is more selling pressure in the underlying than the respective ETF.

In the latter situation, the creations are not the result of “retail demand” but, to the contrary, the outcome of a desire to offload overpriced ETFs to potentially unsophisticated investors who don’t recognise the mis-valuation.

In conclusion, the driver of the AUM growth doesn’t have to be a rush of retail demand. Somebody somewhere has to buy the ETFs being created by the market. This is true. But it is the terms on which they are buying that matters.

ETFs, it turns out, are structurally designed to grow whenever the ETF unit is overpriced relative to the underlying, and contract when it is underpriced relative to the underlying. This makes them countercyclical by design. It is also what makes them so good at calling bottoms, irrespective of what underlying investor sentiment really is.

That’s not to say explosive growth can never mean explosive buying interest among ETF investors. But it can also mean explosive collapse in the underlying — with ETFs structurally and automatically positioned to counteract that selling pressure by absorbing excess supply into themselves via the arbitrage mechanism.

Investors and traders who understand this are better positioned than most to pre-empt explosive fund growth. This can be useful if a fund’s sudden growth goes on to influence its underlying markets disproportionately (à la the USO’s fund rolls) because the fund is now the dominant and supporting presence in those markets.