Uh, What’s Contango?

Before we start, this may be over your head. If it is, I would advise you to do nothing more than day trade ETFs. By doing so, you will avoid contango all together. With that said….

Recent, exchange-traded funds (ETFs) have only grown in popularity among traders and investors. ETFs are typically available at a low cost, and are considered by many to be an easy way to diversify while still holding the luxury of carrying out easy transactions that are very similar to the traditional stock trade.

However, ETFs aren’t limited to stocks and indexes. The ETF database contains a wide range of potential possibilities. You can easily find currency, bond, and commodity ETFs without much research. But, when trading ETFs that contain more complex investments, like commodities or leveraged ETFs, you can run into some issues.



Understanding the Contango Effect on ETFs

Taking longer term investments in commodities can definitely offer diversity in an IRA or other portfolio. Commodity ETFs can be great because they allow traders and investors to dabble in the futures markets, while weeding out some of the complexities that come along with a futures account. However, while making commodity ETFs more accessible, traps have also been set in the process.

Contango is a situation that is possible with any investment that is based on futures. It isn’t the ETF police, or some regulation committee, but a factor of futures contract roll-over. The exact opposite of backwardation, “contango” is when the near-month futures are actually less expensive than those that expire later on. Simply put, it’s futures lag. What’s the reason behind this contango phenomenon? It’s likely due to investors willing to pay a premium to have the commodity in the future rather than covering the cost of storage, and buying the physical commodity today. Storing tanks of natural gas, bushels of corn or barrels of oil isn’t cheap, and those costs have to be passed down the line. (Guess who gets them?)

To elaborate, if the ETF company is holding oil contracts for May, at some point it will have to roll them over to June. If the May contract is worth $36 and the June contract is worth $38, the ETF company is technically selling low and buying high. So, when the contract roll-over occurs, it can easily result in you having bought the ETF at a premium (without realizing), and now having to sell at a lower price. No bueno. If it’s in contango, get out before the expiration or you may see a sharp decline.

I’ve included a link to futures contracts expirations for your reference, as well as a link to VixCentral – a great site to check contango levels.

How in God’s Name Can This Happen?!

Futures contracts provide investors with the right to claim delivery of a specific commodity at a specific point in the future. However, most investors don’t actually receive delivery of this commodity, but close their futures positions before the contract expires. Usually, futures investors who wish to keep their positions will simply roll them forward to the next month’s contract.

Great strategy. And it works beautifully if the price for both month’s futures contracts are the same. However, in most markets, the futures price will vary depending on when you want “delivery” of the commodity. This variation in price-based-on-date is where contango and backwardation come into play.

Contango is bad for certain ETFs because if you’re constantly paying a higher price every month to replace your expiring contract with the next month’s futures contract, you will lose money over time in relation to the movement in the spot price of the commodity. That is exactly what the ETF company is doing, which is with whom you hold your investment, not in the physical commodity. They are holding futures contracts, not barrels of oil or bars of gold.

An example of “contango” is shown here comparing NG expiring in May (blue) to NG expiring in June (red). You can verify contango or backwardation yourself by comparing the two different futures on the same chart.

I’ve included a link to futures month codes for your reference.

contango - NG2

In this example, the May contract price is at 1.954, while the June contract is at 2.05. Thats a $.096, or a 4.9% difference. As a result, ETFs specializing in Natural Gas Futures that use a monthly roll-over strategy currently face headwinds of 4.9% per month against their returns. On a 3x ETF, thats 14.7%.

It only makes sense that contango starts to be much more obvious when investing with leveraged ETFs. Same effect multiplied by the leveraged return. Leveraged ETFs are designed to magnify gains or losses compared to an index. So for example, if you invest long-term in $TQQQ, which is the Nasdaq 100 3x ETF, it’s designed to give a 3x return of the underlying Nasdaq 100 index price action. The issue is that every day the indexing is reset since the ETF is based on futures price. Over time, the returns from the investment won’t match the Nasdaq 100 multiplied by three. $UNG is the infamous example used to show the contango effect of leveraged ETFs. At the time of this article, the ETF is down roughly 97% as of it’s creation. Ya… that’s almost 100.

Due to this effect, a leveraged ETF should only be used as short term (a few weeks maximum) investment.

Avoiding Contango

It is likely obvious to you at this point that long-term trades in commodity ETFs based solely on futures contracts for the next month can end ugly. Still, the threat of contango shouldn’t stop you from adding commodities to a longer term portfolio.

A great book on longer term ETF strategies is ETFs for the Long Run by Lawrence Carrel. Great read for anyone considering long term holds in such funds. Highly recommend.

Numerous fund sponsors have released new tickers that are meant to fight contango. $DBO (PowerShares DB Oil) and $BLND (UBS E-TRACS DJ UBS Commodity Index 2-4-6 Blended Futures ETN) create contango-fighting returns by utilizing “flexible-futures trading strategies,” which include optimized roll yields or blending contracts, rather than just automatically rolling to the next month’s contract.

You can also get the real deal with a few specific commodities. $GLD (SPDR Gold Shares) or $SLV (iShares Silver Trust) actually have the physical bullion in a friggin’ vault held on your behalf. Hell, there is no contango, and no futures contracts to sweat over. While current physical offerings are just limited to precious metals, both copper and aluminum also have physically backed ETFs in the database.

Conclusion

There are ways to use contango in your favor. Many will short 3x ETFs of commodities in a current state of contango near contract time. I’m not advising you to do so… but I’m sure many of you will research or backtest ways to do so on your own. I can’t help but encourage the hunger for knowledge. I might touch on that subject another time…

Just be aware that if you plan to hold a commodity ETF for more than a few weeks, you should do some research into how commodity contracts work, specifically, how that ETF fund handles their contracts. Understand that as the underlying investment on their end becomes more complicated, as does the ETF on your end. While ETFs can be valuable tools to help you catch major moves in commodities, keep the possible risk in mind. The longer you hold, the more you will feel the effects, should futures contracts be in the state of contango.

Understanding Contango

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