Exchange-traded funds (ETFs) are investment funds that trade on a stock exchange. Like a stock, an ETF’s price changes throughout the trading session as shares are bought and sold, and they can be sold short and bought on margin. In addition, ETFs typically are low-cost compared to other investment vehicles, and are considered a relatively simple way to add diversity to a portfolio. Because of their attractiveness to institutional and individual investors alike, ETFs have grown into a $1 trillion industry since the SPDR fund — the first ETF — was launched 20 years ago.
Today, traders and investors can gain exposure to a variety of investment products through ETFs, including bonds, currencies, indexes and commodities (see Futures’ 2013 ETF Guide, page 38). However, even the relatively simple arena of ETF trading has special considerations that must be acknowledged.
In futures-based commodity ETF trading, if the futures contract in which the ETF invests is experiencing contango, the ETF can lose value, resulting in potentially significant — and often unexpected — losses for investors. Here, we will introduce contango and its effect on the futures-based commodity ETF markets, and how traders and investors can mitigate the potentially damaging consequences.
When the forward price of a futures contract is above the expected future spot price, the market is said to be in contango (see “Contango and backwardation in futures markets,” February 2013). This is a fairly common situation because under normal circumstances investors and traders are willing to pay a premium to avoid the inconvenience and costs associated with transporting, storing and insuring a commodity. Further out contracts often are priced higher than current ones.
The price of a futures contract will converge to the spot price as its expiration date approaches as a function of arbitrage, supply and demand. If a contract is priced above the spot price, as is the case with a market that is trading in contango, price eventually must move down to be in line with the spot price. Because contango implies that price must fall, long positions in contangoed markets can lose value. “Contango in action” (below) illustrates this concept.
Although individual investors can participate in the commodity cash market, buying and taking delivery of physical commodities, most prefer the convenience of exploiting price moves by trading an exchange-traded derivative, such as a futures contract or an ETF. ETFs are a popular alternative with the general public because not only do they provide individual investors with direct exposure to a variety of commodities without the limitations of holding the physical assets, but they can be traded in any equity account, just like a stock. Investors can trade ETFs based on various commodity categories, including agriculture (grains and softs), energy and metals.
Some commodity ETFs physically hold the commodity. For example, the SPDR Gold Shares ETF buys physical gold bars and stores them in London vaults. Not all commodity ETFs, however, are structured this way. ETF managers also can replicate the commodity markets by investing in futures contracts. The ETFs United States Oil Fund (USO) and United States Natural Gas Fund (UNG) attempt to replicate the underlying commodity by buying and rolling over futures contracts.
Futures trade at multiple maturities with different prices. As time goes by, long-term investors must perform a regular roll process in which contracts nearing expiration are sold and longer-dated contracts are purchased (assuming a long position; the reverse is true for short positions). For example, if an investor is long the current Henry Hub natural gas futures contract, he simultaneously can sell that month and buy the next-furthest-out contract to maintain the position.
Because the next contract probably does not cost the same as the current one, the roll process can be expensive if the market is in contango. Sometimes, the profit or loss resulting from the roll process can be the most decisive factor in commodity returns, even more so than the spot price. If the market is in contango, it will cost the investor to roll from one contract to the next. Conversely, if the market is in backwardation, where the forward price of a futures contract is below the expected futures spot price, the roll process may be favorable. “Time values” (below) shows prices for natural gas contracts; at this point, the market is in contango through February 2014, with each successive contract more expensive than the previous.
Contango can create strong headwinds and surprise investors who hold long positions in commodity ETFs. If a futures contract in which an ETF invests is experiencing contango, a fund may be forced to sell low and buy high each time it rolls over to the next contract. This may not be significant if it were to occur only once or twice; however, the serial process of rolling from cheap contracts to more expensive ones may cause an ETF’s returns to diverge significantly from those of the commodity itself.
The UNG is an oft-cited example of the trouble contango can cause. UNG invests primarily in near-month natural gas futures contracts. When natural gas futures are trading in persistent contango, as they are frequently, the fund has to sell the expiring contract for a lower price than it must pay for the next contract, resulting in a loss each time the contract is rolled over. Meanwhile, if spot prices are rising, ETF investors may assume incorrectly that the value of the ETF will increase as well. As a result, ETF investors can be blindsided by losses and not even understand how or why they happened.
“Slip slide” (below) compares the natural gas futures contract with the UNG fund. Investors who saw rising prices in the natural gas contract most certainly were hoping for positive returns through the ETF; because of the impact of contango, many were sorely disappointed.
If a futures contract is in contango, any ETF that invests in that contract could perform worse than if it had invested in the commodity itself. Another challenge faced by futures-based commodity ETFs is the possibility that investors might trade ahead of the fund before the roll process.
For example, a large fund may hold billions of dollars in futures contracts. Some investors safely may assume that the fund will not plan on taking delivery of the commodity, and that it must therefore roll over its contracts, selling and subsequently buying billions of dollars worth.
When the fund purchases so many shares of the next contract, prices can be driven up, providing an opportunity for savvy investors to purchase ahead of time at the lower price, and later sell at the higher price. This is good news for the investors who traded the futures contracts ahead of the ETF, but bad for those who are holding the ETF.
Dealing with contango
This does not mean that investors and traders should steer clear of futures-based commodity ETFs. Here are a few strategies for limiting the potentially negative effects of contango:
- Recognize contango. Understand that it can impact ETF returns negatively— even when the related futures contracts are performing well.
- Know your ETF. Understand an ETF’s structure before investing. Look at a fund’s prospectus to determine if it invests in futures contracts or buys and sells spot prices. In general, futures funds will perform worse when there is contango (and better when there is normal backwardation). Be aware of contango in the associated futures markets and plan accordingly.
- Consider other investors. Be aware that other investors may seek profits by trading ahead of large funds, thereby hurting potential profits for the ETF itself. Consider investing in funds that are not as large to limit this possibility.
- Look for funds that hold various length contracts. Because contango and normal backwardation market states can and do fluctuate, a fund that invests in one-month, three-month, six-month and 12-month contracts may be better able to weather contango than one that invests only in the near-month.
Jean Folger is the co-founder of, and system researcher at, PowerZone Trading LLC. She can be reached at www.powerzonetrading.com.