Exchange traded funds have helped retail investors easily access various commodities assets. However, investors should know the risks associated with commodities investments that use futures contracts, which could lead to underperformance and even losses if you are not careful.
Specifically, commodity ETFs and other funds that invest in futures contracts are susceptible to contango in the futures market. [Jim Rogers Benchmarks Guide Commodity ETFs]
Contango occurs when the price on a futures contract is higher than the expected future spot price, which creates the upward sloping curve on future commodity prices over time, writes Aaron Levitt for Investopedia.
Commodity prices are typically higher in the future because people would rather pay a premium to have the commodity on a later date instead of paying the costs for storage and the carry costs for buying the commodity right now.
While this phenomena is a normal occurrence in the futures market, contango can have a negative effect on ETFs. ETFs that hold futures contracts sell the contracts before they mature and purchase a later-dated contract.
In a contangoed market, the ETF loses money each time it rolls contracts to a costlier later-dated contract – the fund would technically sell low and buy high. 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. [Backwardation & Contango]
For example, the United States Natural Gas Fund (NYSEArca: UNG) and the United States Oil Fund (NYSEArca: USO) have seen losses over the long-term due to contango, but they have been fine over the short-term.
Nevertheless, there are a number of funds that utilize a blend of futures contracts with various maturity dates to help diminish the effects of rolling front month contracts, such as the PowerShares DB Oil Portfolio (NYSEArca: DBO) and the United States 12 Month Natural Gas Fund (NYSEArca: UNL).
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.