Sinking Oil ETFs Devour Foolish Money

"Never catch a falling knife." That's one of the age-old adages of market wisdom that gets bandied about whenever markets are dropping. The phrase, of course, suggests that if you buy a steeply and rapidly declining asset, you're likely to get cut.

That's exactly what's happened to the bold but foolish traders who entered in the oil market in July. With a 21 percent loss, the month was the worst for oil futures since the financial crisis in 2008. That's sent oil-linked exchange-traded funds reeling, just as traders plowed hundreds of millions of dollars into them.

Based on the ETF.com fund flows tool, inflows into the United States Oil Fund (USO | B-100)―the most popular oil fund, with $2.5 billion in assets―totaled a whopping $821 million in July.

Even more startling were the inflows into the VelocityShares 3X Long Crude Oil ETN (UWTI), a leveraged product that aims to deliver three times the daily return of oil futures. Inflows into this fund totaled $654 million in July, a massive sum for an exchange-traded product that has $956 million in total assets.

Most of UWTI's inflows came during the beginning of the month, while USO's were spread more evenly throughout the period.

Regardless of when traders bought into the funds, they're likely down big. USO fell 22 percent in July, while UWTI shed 54 percent. Both products are trading near all-time lows, so by definition, everyone who is long is losing money.

This is not to say things can't turn around. Oil could rally in the coming days, weeks or months. If that's the case, perhaps these traders who've bought these products are smart, nimble bargain hunters who are getting in on the ground floor of an eventual oil turnaround.

Unlikely Smart Money
While it's possible and even likely that oil will rebound at some point, it's doubtful these are smart money traders we're talking about. After all, this isn't the first time we've seen big inflows into these two funds.

Traders have been throwing money into USO and UWTI all year long, with nothing to show for it. Since the start of the year, USO inflows have totaled $1.6 billion, while those for UWTI have totaled $1.3 billion.

USO was up at most 2 percent at one point this year, while UWTI has been in the red the whole year. Now the two are down 23 percent and 69 percent, respectively, on a year-to-date basis.

YTD Performance For USO & UWTI

If anything, the evidence suggests that rather than being smart money traders, buyers of USO and UWTI don't have a clue.

Adding insult to injury is the fact that USO and UWTI must contend with issues of their own: roll costs associated with contango, and in the case of UWTI, performance drag from leverage and daily rebalancing.

That means even if traders turn out to be right about oil prices, they could still end up losing money in these products.

Bottom Line

While there are surely some fast-fingered traders out there who are making money by trading these oil products, the majority will end up with big losses.

Anyone looking to buy USO or UWTI should exercise extreme caution, while long-term investors interested in bargain-hunting in the energy sector should take a look at the plethora of energy equity ETFs out there instead.

At the time of this writing, the author held no positions in the securities mentioned. Contact Sumit Roy at [email protected].