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Markets: Oil and ETFs
New York: April 10, 2006
By John R. Stephenson

Today, there is something for investors to cheer about. A new exchanged traded fund ("ETF") based on the price of oil will begin trading on the American Stock Exchange (symbol "USO"). Once the purview of professional traders and nervous amateurs, direct oil investing is going mainstream. This follows closely on the launch last year of the wildly successful exchange traded fund for gold ("GLD") which has allowed investors of all stripes direct and easy access to this commodity.

But why is this something to cheer about? This new ETF will allow investors direct exposure to oil — the single most important commodity there is. Previously, investors who wanted direct exposure to oil had to settle for managing trades in the volatile futures markets. For amateurs, the alternatives before today were just not that enticing — either avoid direct commodity investing entirely, or take your chances with the professionals in the futures markets.

No doubt about it, futures trading can be a boon to investors. But it can also be a bust. For starters, there's a whole new language to learn. And then there's the issue of leverage. Speculators who choose to invest through the futures market place bets on what the price of a given commodity is likely to be at some specific time in the future. If, for example, you think that oil will trade for $72/barrel or higher in January 2007 and the futures contract for January 2007 crude oil is currently trading at $70.51/barrel, then you place your bet and pick up a contract for January 2007 crude oil. For as little as $7,051, you can control $70,510 of crude oil (a 1:10 ratio).

But therein lies the problem with futures trading. Just as quickly as your investment can soar it can also tank. And that leverage that is thrusting your investments higher, can tank your portfolio in a hurry as well. Not to mention the fact that oil is a notoriously volatile commodity (the price varies wildly) whose value depends on a whole bunch of factors, which include the geopolitics of oil, inventories, refining capacity and supply and demand. This multitude of factors conspires to make oil futures trading a difficult and risky enterprise for the uninitiated.

With a new exchange traded oil fund, many of the problems inherent in futures trading have been eliminated. For starters, ETFs trade on major stock exchanges and can be bought and sold just like a stock. The leverage that is employed in futures investing is absent from ETFs and many of the technical aspects of futures investing such as roll risk and the possibility of being stuck with the physical delivery of the commodity (if the contract isn't closed before termination) have been eliminated.

But the best reason to own a commodity oriented ETF is that it gives you direct exposure to the one variable that most impacts the value of commodity oriented stocks — the commodity itself. In buying the stocks of commodity producers, such as major oil companies, you are not only making a bet on the direction of oil prices but also on the management of these companies. While many energy companies have done remarkably well in the past, companies such as Enron have shown that smooth talking executives can hide fundamental problems just long enough to suck in a ton of investors. By investing directly in the commodity itself, the problem of choosing the wrong company at the wrong time has been eliminated.

For investors who hold large energy portfolios, the ease and convenience of short selling (selling shares in a stock or ETF that you don't own in the hope of profiting later by buying it back at a lower price), an ETF as opposed to a futures contract can be a benefit as well. If an investor holds a large portfolio of energy stocks then they might be concerned about a possible pullback in the price of crude oil. By shorting some USO (the new oil ETF) against their portfolio, savvy investors can hedge (defend) against the risk of an oil price collapse — a scenario that would wreck havoc on an energy portfolio.

Without doubt this is just the start of things to come. Pretty soon there will be ETFs for all commodity products — everything from base metals to natural gas and in between. All of this is good news for investors as it allows them to simply and directly add to or subtract exposure to various commodities from their investment portfolios. All with the ease and simplicity of buying or selling a stock.

The move toward commodity-based ETFs will also help retail investors level the playing field with the professionals. For a long time now, professional investors have had extra tools at their disposal by being able to manage the commodity exposures in their portfolios through the use of the futures markets. Now, retail investors will have the same advantages without the disadvantages (leverage, physical delivery etc.) associated with futures trading.

The long march forward for exchange traded funds has just begun. Pretty soon an ETF will be available for just about anything. The benefits of ETFs are staggering for the retail investor. They are easy to buy and sell as well as being inexpensive Unlike active fund management (mutual funds) where big fees come out of investors' pockets to hire top flight investment managers as well as hefty sales loads to compensate investment advisors for selling mutual funds, ETFs are light on management fees. Most ETFs simply mirror the returns of the various indices, since they hold the same stocks in the same proportion as the index, they try and replicate which means investors will likely get the published performance of an index with the diversification benefits of a mutual fund — at much lower cost.

Already, ETFs exist that replicate the performance of most of the major stock market indices as well as many of the foreign markets. A fund that trades like a single stock and can be bought and sold online or over the phone allows average investors to construct winning portfolios at a fraction of the cost of managed funds. Some of the best performing stock markets in the last few years have been those of the emerging markets as well as the Japanese and German stock exchanges. Investors looking for international diversification for their investment portfolios should look no further than some of the various ETFs that are based-upon foreign stock exchanges. Barclays Bank, the global leader in the manufacturing and sales of ETFs, should be a first stop on investors' shopping lists for products of this type.

While a new oil ETF may seem like a small deal, it really isn't. It is just another example of how the investing world is becoming more and more transparent and efficient. In short, investing has just become a little bit more democratic.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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