You need to be aware of the risks involved in investing in Bitcoin, oil and volatility ETFs.
Investors who have invested in commodities and oil ETFs such as United States Oil, Bitcoin ETFs or VIX volatility products were surprised to find that these exchange traded products did not closely track the increase in oil prices or Bitcoin or the spike in volatility on the stock market. These commodity and volatility ETFs, and ETNs, often generated large annualized losses.
The United States Oil ETF, for example, has returned -14.6% annuallyized over the ten-year period ending January 31, 2022. The ProShares ViX Short-term futures (VIXY), ETF, returned -50.3% annually for the ten year period ending January 30th 2022.
Investors should know what drives the performance of Bitcoin, commodities, and volatility-linked ETFs before investing. The roll yield has a significant impact on commodity and VIX exchange-traded fund performance.
Bitcoin volatility and oil ETF performance drivers
The four components of return on commodity and volatility ETFs include:
- Changes in the Spot Price
- The yield
- Interest on Cash Held
- Taxes and Expenses
Spot price return
The spot price is the market price of VIX, Bitcoin, or any asset. The spot price return represents the change from one period to another in the price of VIX, a barrel of oil, Bitcoin or any other a data-cmtooltip=”cmtt_8f84757c5e4e8164f8d90362f4bf0be6″ data-gt-translate attributes='[“attribute”: “datacmtooltip”, “format”, “html”]’
It is impossible or difficult to invest at the spot price in many asset classes, such as oil and VIX. A person cannot store oil in the basement as can gold coins. Investors, including ETFs invest in VIX and oil using futures contracts.
A futures contract is a commitment to buy or sell an asset at a later date. ETFs investing in Bitcoin, VIX or commodity futures will enter and exit multiple futures contracts. The ETF will exit the contract when it is near expiration and enter a new contract with an expiration date a month away or later. The process of rolling forward is also known as a roll-forward.
USO & Negative Oil Prices
If the USO ETF does not exit the contract before its expiration, the ETF will have to purchase oil and store it.
USO and other investors in April 2020 were desperate to get out of the West Texas Intermediate Oil futures contract due to a glut and lack of storage space. The demand to terminate the WTI futures contract that was about to expire was so strong that investors were willing to pay money to get out of the contract.
The spot price for oil is determined by the contract closest to its expiration. When investors paid to leave the WTI oil contracts, the spot price was effectively negative. The oil spot price dropped to negative 37 dollars per barrel at one point.
Roll Yield
Commodity ETFs, Bitcoin ETFs and VIX ETFs can enter and exit contracts for futures to maintain exposure to assets they track. The futures contract owner earns positive returns if the price of the contract increases during the holding time. If the contract falls in price, then the futures holder has a negative return.
The holding period return for investing in a futures contract can differ from the spot price return over the same holding period. The roll yield is the difference between the futures price return and the spot price return. That is all roll yield is–the difference between two returns over the same time period.
There is no cash flow associated with roll yield, which is why the term is so confusing. Yields typically involve receiving cash flow in the form of interest or dividends.
Here is an example to better understand roll yield. Suppose an oil ETF like USO exits a futures contract that is about to expire for $30 a barrel and enters into a new contract that expires a month from now at $32 a barrel. Since the contract is about to expire, the $30 represents the current spot price because that is the price of the futures contract that is closest to expiration. The $32 price represents the market’s expectation of what the oil spot price will be in 30 days.
A month later, suppose the ETF exits the contract that is about to expire at $30 per barrel. Again since that contract is now the closest to expiration, $30 is also the spot price.
In this example, the spot price return was 0% since the spot price was $30 at the beginning of the period and $30 at the end. The ETF that held the futures contract lost $2 on the contract, entering at $32 and exiting at $30. That equates to a 6.25% loss.
The roll yield is the difference between the 0% spot price return and the -6.25% futures contract return. That means the roll yield was -6.25% in this example.
Negative and Positive Roll Yields
When future prices for oil, VIX or Bitcoin are consistently higher than the current spot price, a situation known as either normal futures curve or contango, then an ETF will consistently lose money as it rolls over future contracts if the spot price stays the same. This situation is known as a negative roll yield.
The only way an oil or Bitcoin ETF will earn a positive return when there is a normal futures curve is if the spot price for oil or Bitcoin when a futures contract expires is higher than the oil or Bitcoin futures price at the time the ETF entered the contract.
Otherwise, if the spot price stays the same, when there is a normal futures curve, the ETF will always exit a futures contract at a lower price than it entered it, losing money, month after month.
An inverted futures curve is when futures prices are lower than the current spot price. This is sometimes call backwardation. In this situation, an ETF that invests in oil, Bitcoin or VIX futures will have a positive roll yield as the ETF will earn a profit on the futures contract if the spot price doesn’t fall below the futures price the ETF paid when it entered the contract.
In other words, if the spot price stays the same, the ETF would still earn a profit because it entered into the futures contract at a price below the spot price. That means it will exit the futures contract at a higher price than it paid, earning a profit.
Other VIX, Commodity, and Bitcoin ETF Return Factors
While fluctuations in spot and futures prices are the primary drivers of Bitcoin, commodity and VIX ETFs, there are two additional factors.
The first is the interest that the ETF earns on cash. Futures contracts are leveraged in that an investor can get a large amount of exposure to Bitcoin, commodities and VIX without having to put up much capital. Consequently, commodity and VIX ETFs have large cash balances that they can safely invest to earn interest. That interest contributes to the ETFs’ returns.
Like all ETFs, Bitcoin, commodity and VIX ETFs charge a management fee and incur other expenses that reduce investors’ overall return.
Why Invest In VIX, Commodity, and Bitcoin ETFs
Most of the time, the futures curves for Bitcoin, VIX and commodities is normal in that futures prices are higher than the current spot price. That means ETFs that seek to benefit from an increase in commodity prices or Bitcoin, or a jump in the VIX index will have a performance drag due to the negative roll yield that results from a normal futures curve (i.e. contango). Negative roll yield has been a large contributor to the long-term negative annualized return posted by these ETFs.
Individuals should only purchase a Bitcoin, VIX or commodity ETF if they believe futures prices will be higher not only than the current spot price but also higher than the consensus view about the future price of Bitcoin, VIX and commodities.
Futures prices are based on investor expectations. If the current spot price of oil is $30 and the oil futures for a contract that expires in one month is $32, then an investor will only earn a profit if the spot price 30 days from now is greater than $32.
The spot price when the contract expires needs to exceed the futures price at the time the contract was entered. That futures price represents what market participants expect oil prices to be. Investors in Bitcoin, commodity and VIX ETFs will only make money if prices for Bitcoin, commodities and VIX surprise to the upside.
Investors in Bitcoin, commodity and VIX futures ETFs should consider whether they have any insight to suggest the consensus view about prices in the future are wrong. Because due to negative roll yield, the consensus of investors needs to be wrong for investors to earn a profit investing in Bitcoin, commodity and VIX ETFs.