Commodity ETFs: Understanding Contango
March 8th 2011 at 11:00am by Tom Lydon
The rising cost of commodities has a growing number of investors exploring their options for getting exposure while hedging the loss in their pocketbooks. If you’re one of those investors, be forewarned: commodity exchange traded funds (ETFs) need to be understood.
As the saying goes, not all commodity ETFs are created equal. Many commodity ETFs are constructed in ways that prevent them from delivering perfect tracking of the spot price of their underlying commodity, or even with other seemingly comparable funds. [The Effect of Contango On Commodity ETFs.]
Here’s what you need to know about futures-based commodity ETFs, says Jeff Benjamin at Investment News, which are becoming an increasingly common way to get exposure to rising prices:
- It’s not a flaw that futures-based funds don’t necessarily track the spot price. The pricing characteristics of futures contracts are what cause commodities ETFs to veer off from the spot price of their underlying commodities.
- During a period when commodities prices are rising, futures contracts — which obligate a buyer to purchase the commodities in the future — keep getting more expensive than the prevailing spot price.
- This pricing condition is known as contango. When futures prices are lower than the spot price, due to expectations of an economic slowdown or a glut of supply, for example, commodities are said to be trading in backwardation.
Contango in the commodities markets is a normal state of being, and investors need to understand that it isn’t a bad thing, but they do need to watch it and understand it. Financial advisers and investors can navigate the negative effects of contango by seeking out more-diversified commodities exposure and funds that use flexible-futures trading strategies instead of automatically rolling to the next month, such as Teucrium Crude (NYSEArca: CRUD) or PowerShares DB Oil (NYSEArca: DBO).
Tisha Guerrero contributed tot his 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.