What is an ETF? — Part 23: Backwardation and Contango
September 5th 2012 at 4:07pm by Tom Lydon
Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 22: Commodities]
When it comes to looking at futures-based commodity ETFs, investors should be aware of the basic shape of the futures curve as it provides traders with a sense of whether or not the commodity futures markets are in backwardation or contango. ETFs designed to track futures contracts can be helped or hurt by the shape of the curve.
Ordinarily, futures contracts with a longer expiration date have a higher price, compared to the spot price – this may be attributed to pricing for storage of the physical commodity or other financing costs in today’s price.
As a contract moves closer to the expiration date, the futures price needs to converge with the spot price – traders would arbitrage the difference until no profit can be made, causing both the futures and spot price to meet.
If longer-dated contracts are more expensive, the futures market is said to be in a state of “contango.”
In contrast, if the futures price is below the expected spot price, the futures market is said to be in a state of “backwardation.”
Typically, a futures-based commodity ETF trader would benefit if the underlying commodity is trading in backwardation. Since ETFs have to roll futures to avoid physical delivery of the commodity, a fund gains a profit every time it rolls to a cheaper later-dated futures contract in a backwardated market.
In a contangoed market, the ETF loses money each time it rolls contracts to a costlier later-dated contract. Additionally, potential investors should note that in a contangoed market, futures-based commodity ETFs can experience heavy losses even if the underlying commodity’s spot price rises.
For past stories in this series, visit our “What is an ETF?” 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.