World’s largest oil fund rule change shows how no ETF is truly passive

ETFs and index funds may allow investors to passively track the market, but how they do so always involves some level of decision-making.

The world’s most popular oil ETF, USO, has announced a drastic shake up in regard to how it invests, blurring the line between active and passive management.

The ETF has announced it will sell all of its June futures contracts, which account for about 20% of its $3.6bn portfolio, over the next few days. It will replace these with contracts dating between July 2020 and 2021.

This seems to make sense. Last week saw May futures for WTI oil trade at negative prices owing to a shortage in storage. USO avoided getting caught up in this having already sold its May contracts, rolling them over into the next month a few weeks prior, as per the rules of the fund.

Historically the fund “rolls over” its front month contracts two weeks before expiry. As the fund’s prospectus says: "USO's benchmark is the near month crude oil futures contract traded on the NYMEX. If the near month futures contract is within two weeks of expiration, the benchmark will be the next month contract to expire."

The fund recently made slight alterations, opting in mid-April to move part of its portfolio into contracts for later delivery due to strong inflows risking US rules that limit position sizes.

The latest rules, however, have seen USO diversify its holdings much further. The fund now intends to have 30% of its holdings in July contracts, 15% in August, September, October and December contracts and 10% in June 2021 contracts.

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All these changes appear to make sense, with the storage issue that resulted in negative prices last week far from resolved. Had the ETF continued to hold close dated contracts and rolled them over as it had historically done it risked either large losses by rolling potentially rock bottom June contracts into July contracts (so-called Contango) or selling negatively priced contracts. In the case of the latter, that would have likely resulted in the fund closing.  

The ETF is essentially a pot of money used to buy oil futures in some structured way. In our pre-coronavirus world most people would have assumed that the ETF could, at worst, lose 100% of its investors’ money if some freak event sent the price of oil crashing to the ground.

However, in a world where oil price contracts have been shown to trade at negative prices, there is now the risk of losses exceeding 100%. Investors in the ETF cannot be asked to stump up more for any losses greater than the money they’ve invested, meaning the provider of the ETF would be on the hook. Most likely, the ETF would close.

Therefore, the decision to dump June contracts early makes sense. As noted above, the fund had already recently changed its rules. Indeed, in its 21 April filing with the US regulator, the day after May futures went negative, the fund had said it would make changes to its investment strategy due to “extraordinary market conditions in the crude oil markets.”

But as sensible as the decision appears, it raises questions about whether the ETF is actually a passive vehicle. Making such decisions goes against the philosophy of passive management. The fund’s managers decided to change how the ETF invests based on market conditions. That is the remit of an actively managed fund.

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Even smart-beta ETFs, a halfway house between active and passive, set automated rules about how to invest which are adhered to regardless of the outlook for the market.

Part of the problem is the nature of the oil market. The market is made up of futures contracts trading at different prices, meaning there is no simple or single way to simply gain “market exposure” as you can do by tracking equities indices. As Izabella Kaminska has noted in the Financial Times’ Alphaville: “It’s clear that some degree of active management was always baked into the USO from its inception due to its dependence on derivatives.” Indeed, as Kaminska notes, the ETF has a history of changing its investment rules, most notably in 2009.

However, the current crisis has seen several ETFs, even those tasked with tracking equities, change their rules. Most notably, State Street announced earlier this month that SPDR S&P 500 ETF, or SPY, the world’s largest ETF, would suspend rebalancing until June. The reason, predictably, “extreme global market volatility.” Several index providers also chose to postpone a quarterly rebalancing.

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There’s plenty of good reasons for this, including preventing the forced selling that rebalancing causes. But from the perspective of the investor, such decisions mean they now hold a product slightly different to what they may have imagined. USO investors now have oil exposure in a slightly different way whilst SPY investors are no longer rigidly tracking the US index on a price-weighted basis. The changes may be beneficial or minimal and allowed in the fund’s rules, but it is a change nonetheless.

There’s not much investors can do here but it is a timely reminder that even passive management is not completely passive. Those who provide the index funds still make decisions about how to capture the market’s broad returns. ETFs and index funds may allow investors to passively track the market but how they do so always involves some level of decision-making.