U.S. Oil Fund (USO) is making headlines. In a short and somewhat unusual statement, the CFTC today said it is investigating the trading activity of multiple market participants, including USO. The statement raised eyebrows because the regulator typically doesn’t comment on ongoing investigations.

Specifically, the CFTC is looking at activity in crude oil markets on Feb. 6. That’s the day that USO “rolled,” or sold the expiring front-month oil contract and purchased the successive month’s contract. Read full MarketWatch story.

This is certainly an interesting story that bears watching. It doesn’t look like USO has done anything illegal. The CFTC said Friday’s announcement was related to its ongoing national crude oil investigation.

When oil was surging last year, some were blasting commodity index funds. There were claims that index traders were pushing up the price of oil or distorting the market, and that more disclosure was needed. Some estimated that 60% of crude oil price was pure speculation mainly by institutional investors and hedge funds.

Maybe we just needed a scapegoat for surging oil and gas prices last year. Blame the evil index speculators!

Some commodity ETFs like USO and the largest gold ETF (GLD) are attracting more attention due to their sheer size. For example, USO has more than $4 billion in assets. On Feb. 6, March oil futures — the front-month contract at the time — lost more than 2% in trading on the New York Mercantile Exchange as USO rolled its holdings into the April oil contract. The ETF announced recently that it will change its procedure and use four days for the roll-over, rather than one day.

The situation USO may be causing in the crude futures market is reminiscent of the so-called index effect in the stock market. There is a ton of money indexed to the S&P 500. Standard & Poor’s announces the index additions and deletions ahead of time. With all that indexed money scrambling to buy and sell the affected stocks, the shares can be pushed around even if there is no corporate or market news. Traders know index funds need to buy or sell the stocks, so they try to profit by getting ahead of the trades. This only adds to index effect.

Something similar appears to have happened with USO given its size. It rolled all its contracts in a single say, which swamped the market. Again, any impact could be magnified by traders looking to exploit USO’s trades because they were known in advance. USO lengthening the roll period should help, as would anything else it could do to conceal its trades.

They may be fun to write about, but two new exchange-traded notes following the market’s “fear index” haven’t gotten a big reception from the market. Barclays in late January launched iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (VXZ).

The ETNs track indexes designed by Standard & Poor’s. The benchmarks follow futures contracts based on the CBOE Volatility Index, or VIX. As of yesterday, VXX had assets of about $24 million, while VXZ had roughly $15 million. The credit risk in ETN products could be a factor behind the cool reception so far. Read more on the VIX-futures ETNs.

Also, IndexUniverse.com editor Matt Hougan says what traders want is the VIX spot price, and these futures-based products don’t deliver that. He’s right. In less than a month of trading, VXX has at times diverged substantially from the VIX spot price.

The ETNs “have some very unusual possible return characteristics, so that it’s not just enough to make the right choice about where volatility is heading,” Hougan said. “You have to understand the interplay between daily VIX and the [longer-dated futures] contracts.”

The VIX-futures ETNs have moved higher in the few weeks they’ve been trading on NYSE Arca. The VIX has been rising in February on growing unease over the financial bailout plan and widening economic problems.

However, iPath S&P 500 VIX Short-Term Futures ETN (VXX) was down about 6% in afternoon trading Tuesday as stocks recovered some of their recent losses.

Gold is trading over $1,000 an ounce and the market seems convinced that the nationalization of Bank of America and Citigroup is inevitable.

Financial stocks have been getting slapped around all week and were sharply lower again early Friday amid the latest market sell-off.

Financial ETFs fell to new all-time lows Friday as shares of BofA and Citi were both down more than 10%.

The losses in banking and financial ETFs are truly stunning.

The Financial Select Sector SPDR Fund (XLF) is a highly traded ETF indexed to large-cap financial stocks. The ETF, launched in 1998, dropped to a fresh low of $7.07 a share in early action Friday. It hit an all-time high of $38.15 in May 2007, so it is facing a loss of about 80% since then.

Meanwhile, the SPDR KBW Bank ETF (KBE) also set a new low Friday of $10.12 a share. The bank-stock ETF, which was listed in 2005, hit an all-time high of $60.41 in February 2007, according to FactSet Research.

Exchange-traded funds saw nearly $200 billion move in the door last year while mutual funds had net outflows.

Part of the reason for this is the growing use of ETFs by retail investors and so-called fee-based financial advisers. Fee-based advisers charge clients a flat fee or a percentage of assets, which can guard against conflicts of interest. They aren’t compensated by sales commissions on investment products.

Also, more financial advisers are using low-fee, indexed ETFs in asset-allocation strategies, according to a new report that forecasts assets in U.S.-listed ETFs will reach the $1 trillion milestone within several years. At the end of 2008, ETF assets stood at about $500 billion but fell during the year as a result of declining markets.

“The simultaneous growth in the industry of asset allocation and fee-for-advice compensation models help support ETF growth,” according to the executive summary of a new research report from Strategic Insight. “The ability to trade ETFs intraday is a key feature for institutions and some financial advisers, and recent market turbulence has highlighted ETFs as trading vehicles.”

Strategic Insight estimates as much as half of ETF assets are held by institutions, including pension funds, hedge funds, endowments, foundations, proprietary trading desks and mutual funds. The rest is held by retail investors, including financial advisers. ETF providers have spent considerable time and money trying to reach financial advisers, especially as the business moves increasingly to a fee-based model.

“At some large ETF sponsors, new ETF sales are skewing a little more heavily toward retail than institutional. This suggests a gradual deepening and broadening of the retail ETF market,” said Strategic Insight, adding that some financial advisers use ETFs in “core-satellite” portfolios.

Yet ETFs still haven’t made much headway cracking the massive 401(k) retirement-plan market, which is dominated by mutual funds.

Strategic Insight estimated that in most cases, individual investors are using ETFs as a substitute for stocks or separately managed accounts, rather than actively managed mutual funds.

“However, this mix is gradually changing as ETFs penetrate deeper into the investment world,” the research firm said. “While ETFs are only slowly emerging as substitutes for actively managed mutual funds, their potential is already pressuring managers of traditional mutual funds.”

Looking ahead, all investment products will suffer while the market outlook remains bleak, while “compensation issues limit how quickly broker-dealers will adopt ETF use.” However, more firms such as Pimco and Schwab are getting into ETFs, while the reception of actively managed products is a “wild card” for growth in coming years, according to Strategic Insight.

Exchange-traded funds did a decent job overall of staying close to their tracking indexes in 2008’s whipped-up markets. This of course meant that most funds suffered horrendous losses last year.

Still, investors pay close attention to so-called tracking error because most ETFs and ETNs are designed to provide index returns, minus fees and taxes. It is also a good gauge of how skilled the ETF manager is at delivering performance that closely reflects the benchmark.

For 2008, average and weighted-average tracking error for all U.S.-listed ETFs was 52 and 39 basis points, respectively, according to new research from Morgan Stanley.

However, some ETFs did fall well short of their tracking indexes last year, and in some cases this had to do with SEC diversification requirements. In particular, the iShares FTSE NAREIT Mortgage REITs (REM) and Vanguard Telecom Services ETF (VOX) had big negative tracking error, according to Morgan Stanley.

For the year ended Feb. 3, the mortgage-REITs ETF lost 50.6%, while the index was down 40.2%, according to iShares.com.

Some ETFs tracking specialized indexes also had negative tracking error last year, including a popular dividend-focused fund, iShares Dow Jones Select Dividend (DVY).

The dividend ETF’s tracking error in 2008 was “negatively impacted by a high degree of turnover in its benchmark resulting from many higher-yielding companies significantly reducing (or eliminating) dividends and, thus, being removed from the index,” Morgan Stanley analysts wrote.

“Some ETFs follow newer or less well-known benchmarks that may be harder to track,” they added.

ETFs with bigger expense ratios tend to have higher tracking error because fees come directly out of investors’ bottom line.

Also, some funds may experience tracking error because diversification rules don’t allow them to fully mirror the index by taking a huge position in one or two stocks, for example. Morgan Stanley pointed to Vanguard Telecommunication Services ETF (VOX). AT&T made up about half of the market-cap-weighted index, so Vanguard “optimizes” the portfolio to get as close as possible to the index while still meeting diversification requirements.

“AT&T returned 28% last year, which was 10.5% above VOX’s 2008 return,” Morgan Stanley noted. “This disparity partially explains VOX’s negative tracking error of roughly 569 basis points in 2008.”

Naturally, most investors don’t complain a lot when their funds have positive tracking error. One notable example was a large, optimized ETF for emerging markets stocks, iShares MSCI Emerging Markets (EEM).

With ETFs that track indexes holding thousands of securities, the manager often won’t buy every stock or bond, especially the smaller and less liquid ones.

Kudos to the managers of Vanguard Total Bond Market ETF (BND), which holds a representative sampling of its underlying index.

BND holds 3,731 of the 9,168 securities in the bond tracking index, according to Morgan Stanley. “In our view, this type of optimization could lead to modest tracking error. However, BND’s 2008 pre-expense return differed from its benchmark by only five basis points.”

Barclays Bank on Friday listed a pair of exchange-traded notes tracking futures based on the VIX, an index used by investors to gauge markets’ expectations of volatility. In market panics, VIX tends to spike.

The iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) began trading Friday on the NYSE-Arca stock exchange, Barclays said.

These are interesting yet tricky products, and were discussed in this week’s ETF Investing column.

Hedge fund manager David Einhorn is heeding his grandfather’s counsel and buying gold for the first time, Bloomberg reported. Einhorn, who runs Greenlight Capital, in a Jan. 20 letter to clients said the size of the Federal Reserve’s balance sheet is exploding, and the currency is being debased. Many economists are warning that inflation is the inevitable result of higher government spending to battle the economic crunch.

Aside from buying gold, Greenlight has added call options on gold and the Market Vectors Gold Miners ETF (GDX), according to Bloomberg. Although it’s pulled back lately, the ETF, which tracks gold-miner stocks, has gotten off to a strong start in 2009.

At the same time, an ETF that holds gold in a vault — SPDR Gold Shares (GLD) — is at record levels. Investors have been piling in and the ETF now holds more than 800 metric tons of gold.

Elsewhere in commodity ETFs, FT Alphaville reports on the unprecedented inflows into oil funds.

Yes, Dorothy, people do speculate with ETFs …

In fact, monitoring ETF flows can give a good sense for where the hot money is running and where the next speculative bubble may be forming up.

Aside from gold and oil funds, leveraged ETFs designed to short Treasury bonds have garnered a lot of attention lately with all the talk of a bubble in Treasurys.

Meanwhile, ETF providers are rolling out more funds indexed to mortgage-backed bonds for brave investors who want to try and call a bottom in that sector.

Investors have been piling into gold as a safe heaven with stocks all over the map. A massive ETF, SPDR Gold Shares (GLD), is up about 25% over the past three months and was rallying on Friday as investors’ mood over the economy darkened.

The scale of the gold ETF is staggering. Its value is more than $20 billion and it holds over 800 metric tons of the precious metal. That’s more gold than a lot of developed countries have in their reserves.

The drumbeat grows louder for Barclays and State Street. Shares of the ETF managers were down sharply again in early U.S. trading Friday even though the broader financial sector was higher.

State Street shares plunged nearly 60% on Tuesday and have been extremely volatile all week. The conservative bank had been seen as a cut above but is now facing serious questions, particularly about off-balance-sheet vehicles that issued asset-backed commercial paper.

The picture at British banking giant Barclays, which oversees ETFs and ETNs, is also grim. After the U.K. government’s latest bailout efforts, investors are worried the banks could face additional big losses. Barclays shares are off about 70% so far in 2009. State Street, meanwhile, has seen its stock halved and there is speculation the company is an acquisition target.

Ian Salisbury at The Wall Street Journal today writes about anxiety over Barclays’ ETNs with talk the bank could end up nationalized.

ETFs and ETNs have subtle differences in terms of risks, but the bottom line is that the swoon in Barclays and State Street shares is unnerving for investors in all exchange-traded products. See this blog post at for more.

Also, Morningstar takes a hard look at the risks facing ETF and ETN investors here and here.

In a blog post yesterday I briefly discussed the recent sell-off in an exchange-traded fund indexed to preferred shares of financial companies: PowerShares Financial Preferred Portfolio (PGF).

It’s slumped in the past two weeks on concern more banks may be nationalized. If this happens, holders of preferred securities could be wiped out. (This happened to Fannie and Freddie preferred holders).

Not to pick on “the nation’s most trusted financial advisor,” but Suze Orman on Jan. 12 recommended PowerShares Financial Preferred Portfolio on CNBC, praising its fat dividend yield. The ETF closed at $14.65 on Jan. 12. The fund is down today trading hands at $10.16 in recent action, so its price is off about 30% since that suggestion.

In fairness to Orman, anyone brave enough to make an investment call in this wild market has a decent chance of being burned. Admittedly, I wrote about PGF in November when it was yielding around 10%. However, the column clearly outlined the considerable risks in this ETF and warned it could take a hit if more banks collapsed. The lesson here is that big yields often carry with them big risks.

“The state of the financial system is expected to amplify the volatility of this fund and should serve as a reminder to any would-be investor that there is still a decent amount of risk inherent in this ETF, despite it being composed of preferred shares,” says Morningstar ETF strategist Paul Justice.