The Effect of Contango on Commodity ETFs

February 25th at 1:00pm by Tom Lydon

With the advent of exchange traded funds (ETFs), the average investor is now capable of accessing the commodities market with the click of a mouse. If there’s one thing you must understand before you start clicking, it’s the impact of contango.

Commodity ETF investors may gain exposure to the market through commodity-producing companies, funds that try to track the spot price or derivatives like futures, comments Ben Baden for U.S. News & World Report.

In the futures market, a commodity’s futures price could become higher than its current spot price, and even if the spot price of a commodity rises, an investor may still lose money. Kathryn Young, a mutual fund analyst at Morningstar, remarks that “a contango market is more likely to happen when inventories of the commodity are high because, basically, the opportunity cost of storing that commodity goes up when people don’t need it right now,” and “if inventories are very low, people are willing to pay a premium to get the commodity now.”

An ETF that holds futures contracts is going to have worse returns than the physical commodity if the market remains in contango, because the fund manager has to go in and buy a more expensive futures contract. Depending on market conditions, contango may continue for months.

You can mitigate the portfolio hit from contango by investing in broad-based funds that hold a number of commodities since it is rather unlikely that all the commodities would experience contango at the same time. Christian Magoon, CEO of asset management consultant firm Magoon Capital, suggests investing in equity energy plays like SPDR S&P Oil & Gas Exploration & Production (NYSEArca: XOP), which won’t be affected by contango in oil futures, or diversified commodity funds like the PowerShares DB Commodity Index Tracking (NYSEArca: DBC). [Oil ETFs Surge As $100 Oil Returns.]

You can also look for ETFs that incorporate contango-mitigating strategies, such as PowerShares DB Oil (NYSEArca: DBO) or the newly-launched Teucrium Crude Oil (NYSEArca: CRUD).

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.