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.