Commodity exchange-traded funds, or ETFs, were created early in the last decade to give retail investors an easy way to play hard assets such as oil and natural gas and metals in one broad investment vehicle.

And the strategy has worked—in spades. A low fee structure, preferential tax treatment and strong marketing have propelled commodity ETFs to $97.8 billion in assets under management as of September 30 2010, according to industry data from BlackRock, one of the largest ETF issuers. BlackRock's data also indicate that overall ETF assets at the end of September were just under $800 billion and growing—up 13% over 2009.

Now, almost 10 years after ETFs' launch, retail investors have a lot of access—31 energy ETFs and related products alone; 890 total, across all sectors in the U.S.; and 149 new ones just this year. But quantity hasn't equalled simplicity.

Management from even the most straightforward—and largest—energy ETFs have had to defend themselves at congressional hearings in describing how their funds work. And other energy ETF issuers have launched products that use new and different ways to both track commodity prices and increase returns.

With all the choices of energy ETFs and the confusion around how they work, how can investors decide which one is right for them? And more importantly, how can they make money at it?

Choosing ETFs

ETF issuers and independent analysts say investors need to know the answers to three basic questions before making a purchase:

  • What is the timeline of the trade?
  • Is the futures market for that commodity in contango or backwardation?
  • Do you know what you're buying? ETFs now have very different exposures to energy prices.

"It's not that complicated," says John Hyland, chief investment officer for U.S. Commodity Funds LLC, which issues the United States Oil Fund LP (USO-NYSE) and the United States Natural Gas Fund LP (UNG-NYSE).

"By the time you've answered question No. 1 and No. 2, your choices have now been limited to a couple ETFs—those questions have done 90% of the work" for investors looking to invest in ETFs, he says.

"If someone comes to you with a bond, you ask what the time frame is (until maturity), and ask yourself are interest rates going higher or lower over that time, and then you pick what you're going to do. I don't think it's any more complicated than that, really," Hyland concludes.

Michael Johnston, senior analyst at ETF Database in Chicago, agrees, adding, "What we find is that people don't understand how they're getting exposure" to the underlying commodity when they buy ETFs.

An energy ETF can try to track the spot commodity price, or an oil and gas stock index, or a basket of stocks—or, as the market is seeing now, the ETF can track a custom product that the issuer has made up itself.

But Hyland's USO and UNG are by far the largest and most liquid investments in the energy ETF world, and they use—in fact, most issuers use—the futures market to run their ETFs.

And using the futures market is where the biggest frustration for investors becomes apparent, in the cost of "rolling" futures contracts. Knowing how the futures market works, not just how the spot price market works, is key in who wins or loses in ETF investing.

"Some investors came into ETFs looking at spot prices to gauge the success of their investment, but that exposure is not something you can always achieve," says Bryon Lake, senior product manager for Invesco PowerShares, an ETF issuer. "The next best thing is to use a futures contract."

But the wild volatility in energy prices over the past two years brought about the near-market collapse in 2008, and the recovery so far in 2009-2010 has meant that the futures market sometimes did not track spot prices.

Tracking the Future

Most energy ETFs actually track a futures contract, not spot prices. And during volatile markets, investors were getting the former, when they thought they were getting the latter. That made for some big discrepancies in 2009; Johnston says the price of natural gas was only down 1% on the year but Hyland's UNG ETF lost half its value. (Johnston wrote in March 2010 that while UNG continues to decline, it is actually tracking the natural gas price almost perfectly once the wild volatility stopped.)

So understanding the future—not just the present—is very important to returns. And this is where the two basic questions for investors get answered.

What is the timeline of the trade? The real question here is, how many times does the ETF have to "roll" its futures contracts between now and that trade date?

Use oil as an example. Because the ETF issuers never want to physically own the oil, they must sell their futures contract before it expires, at which point they would need to take possession. So they sell it and buy a longer-dated futures contract—either the next month or several months out. This buying and selling of futures is called "rolling" it forward.

Are the futures contracts showing higher prices (in contango) or lower prices (backwardation)? When the market is in steep contango or backwardation, that is to say when the futures market is very different than the spot price, indicating a big move in commodity prices, the ETFs get caught in a tight spot.

InvescoPowerShares' Lake explains: "If you're rolling into a contango market, an upward sloping curve, you will roll into a more expensive contract, and there will be a drag on performance." (The PowerShares oil ETF symbol is DBO-NYSE.) "We use a more flexible rolling strategy, so we can reduce the impact of contango and increase the benefits of a backwardated futures market."

In 2009, that drag was severe, as the spot price of oil rose almost 70%, and the futures market correctly anticipated that move, as there was a ladder of higher prices in the futures contracts. The problem: ETFs had to sell their lower-priced contracts that were nearly expired and buy the more expensive contracts dated farther out. And the more often they rolled, the greater divergence there was between spot prices moving and ETF prices moving.

That scenario caused many retail and professional investors, like Philip Treick, managing partner of Thermopolis Partners, to avoid going long the ETF sector.

"The contango futures curve forces an ETF manager to sell the current expiring contract low and buy the replacement contract higher—hardly a recipe for success," says Treick, who manages two natural resource funds out of San Francisco and Jackson Hole, Wyoming.

"Institutional and individual investors bought these ETFs hand over fist assuming they were gaining exposure to a rising commodity price when actually, the roll was obliterating returns."

In 2010, however, Hyland says it has been a different story.

"Year-to-date, the amount of contango in the front-month oil contract for WTI has been eroding a bit more than 1% from the return. If someone is looking at this investment as a three- or four-week play, how much do they care about contango or backwardation? It's not that you won't feel it, but in the bigger picture, how much does it really matter? In any single day the spot oil price often moves 1% to 1.5%.

"But if you're looking at 12 months, then it's a bigger factor."

In other words, the trade timeline is greatly affected by the roll.

Hyland's funds continue to roll their contracts forward monthly, to the nearest contract. While this is simple, it also increases any distortions from contango or back­wardation. Other ETFs, like PowerShares' DBO, use a more flexible strategy that can roll once or many times a year.

Morningstar ETF analyst Abraham Bailin says the ETF issuers are evolving their products to meet the market's concerns about the roll.

"Futures-based funds are using dynamic strategies, like USCI, The United States Commodity Index Fund, for instance. They can choose contracts out as far as 12 or 13 months, that can maximize gains or minimize losses posed by the implied roll yield. Some of these dynamic methodologies are getting very crafty."

USCI trades all commodities, not just energy, and will buy futures in backwardation, where it can sell higher-priced, near-term futures contracts and buy lower-priced contracts farther out in time, pocketing the difference.

Tax Issues

A secondary characteristic of ETFs that few investors pay attention to is their tax treatment, which depends on the funds' structure. The Wall Street Journal reported in April of this year that ETF holders could get taxed at 23%—higher than the 15% rate investors are used to paying on stocks and mutual funds in the U.S.—on gains they haven't taken yet under I.R.S. rules, which state that open positions in futures contracts are to be "marked to market" at year-end.

"We find it (futures-based commodity funds) irritating to customers at tax time," says Richard Shaw of QVM Group, South Glastonbury, Connecticut. He buys a lot of ETFs for his clients, and writes about them as well—but he doesn't buy energy ETFs, because of the roll issue, and "they are taxed in complicated ways. A CPA has to take more time."

There are other issues with energy ETFs as well. Sometimes the popularity of an ETF will cause it to trade above its net asset value if the issuer is not granted permission to increase the number of units. Professional traders claim they can "front" the roll at the expense of other ETF shareholders, by buying large amounts of the same futures contract that the ETF does—just before the ETF buys it. They then sell into the ETF buying.

There are also a growing number of levered commodity ETFs, which try to give investors two or three times leverage to the moves in commodity prices or commodity indexes or commodity equities. These often take the form of exchange-traded notes, or ETNs, which have completely different issues for investors and taxation methods.

But for ETFs, understanding how the futures market works, and how the ETFs play that market, are two sides of the same coin that investors must have comfortably in their pocket before spending a dime on the funds.

People invest in ETFs like they would a stock, but because of the way they are structured, they act more like a bond. Like a bond-maturity date, the futures market tells investors where their investment in a futures-based ETF is likely headed, and they need to determine which ETF product gets them there the most profitably.

Keith Schaefer is editor and publisher of the Oil and Gas Investments Bulletin at oilandgas-investments.com.