“Know what you own, and know why you own it.” – Peter Lynch

1. What do you own?

2. Why do you own it?

3. How long do you plan on holding it for?

So simple, it seems, but there are many investors who cannot answer these three most basic questions.

At the end of last year, an acquaintance told me that he had purchased the United States Oil Fund (“USO”). In his view, Crude Oil was going higher and in buying USO he would stand to profit when it did. How has his prediction played out?

Pretty good, if looking at the spot price of Crude Oil, which is up over 30% through September. But in assuming the USO ETF would closely approximate this gain, he couldn’t have been more off, with USO down 1% over the same time period.

What did he get wrong?

For one thing, he did not know what he owned. Yes, he knew the ticker, but like undoubtedly many others in the USO ETF (over $3 billion in assets), he thought he was getting the spot price of Crude Oil when really he was getting Crude Oil futures. They are not the same thing.

One can learn that in reading the 68 page USO prospectus, but as we know no one reads such trivial things. And even if one did bother to read the entire prospectus, the jargon is so thick that even many investment professional would have a hard time understanding what they were reading.

I’ll try to break it down here in simpler terms.

USO is designed to track the “daily” price movements of West Texas Intermediate (“WTI”) light, sweet Crude Oil. The word “daily” is very important as it implies that one cannot assume, in any period more than one day, that USO’s return will mirror the return of Crude Oil.

Why?

Because, again, USO is not buying Crude Oil and storing it. It is not the Strategic Petroleum Reserve. It is buying the “front month” Crude Oil futures contract (closest to expiration) and rolling that over into the “next month” (2nd closest to expiration) when the contract approaches expiration.

In this “roll,” problems can arise when the next month contract is higher than the front month contract. This situation is known as “contango” and looks like this:

Are you still with me?

Good. The problem with contango is that you are buying the next month contract at a higher price than the front month contract you have sold. And if nothing changes over the next few weeks (contango persists and the spot price of Crude Oil hasn’t moved), the next month contract will move down to the spot price over time as it becomes the new front month contract. Then, when you “roll” again the following month, you lock in a loss as you sell at that lower price.

Over time, if contango persists, these losses or underperformance versus spot Crude can add up. Looking at the history of the USO ETF, Crude futures have been in contango most of the time.

(Click on image to enlarge)

The result? USO is down 84% since inception in 2006 versus a loss of 28% in the spot price of Crude Oil over the same time period. This is a stunning gap, particularly for those investors who thought they were getting spot Crude Oil in buying USO.

(Click on image to enlarge)

Now, one could argue that in the future we’re going to see backwardation (downward-sloping futures curve) instead of contango which would have the opposite effect, with USO potentially outperforming the spot price. Perhaps we will or perhaps contango will continue to be the norm. I don’t know and neither does anyone else.

Which is all the more reason to question the logic of investing in something where you couldn’t predict how it would perform even if you could accurately predict the performance of the underlying asset. You don’t ever really know what you own with USO over long periods because it is highly dependent how the futures curve and path of that curve will look.

In reading their prospectus, it may also be dependent on whether “parties involved with USO” choose to “act in a manner other than the best interests of USO and the shareholders,” which said parties seem to be allowed and incentivized to do. From page 16:

“USO is subject to actual and potential inherent conflicts involving USCF, various commodity futures brokers and Authorized Participants. USCF’s officers, directors and employees do not devote their time exclusively to USO. These persons are directors, officers or employees of other entities that may compete with USO for their services, including the Related Public Funds. They could have a conflict between their responsibilities to USO and to those other entities. As a result of these and other relationships, parties involved with USO have a financial incentive to act in a manner other than in the best interests of USO and the shareholders. USCF has not established any formal procedure to resolve conflicts of interest. Consequently, investors are dependent on the good faith of the respective parties subject to such conflicts of interest to resolve them equitably. Although USCF attempts to monitor these conflicts, it is extremely difficult, if not impossible, for USCF to ensure that these conflicts do not, in fact, result in adverse consequences to the shareholders.”

But I digress. This post is not about one flawed product but what such a product tells you about the end investor – that they cannot answer the 3 most important questions in investing.

Who can answer it? Anyone with the discipline and mental fortitude to keep it simple…

1. What do you own?

A diversified portfolio of asset classes that I will stick with over time (matches my risk tolerance).

2. Why do you own it?

Because holding such a portfolio is the only proven road to investment success (highest probability of meeting my goals).

3. How long do you plan on holding it for?

As long as my risk tolerance and goals don’t change.

If this sounds awfully dull when compared to speculating on the price of Oil, good. For successful investing is not supposed to be exciting or entertaining; it’s supposed to be profitable.