Commodity ETFs: Understanding Contango | ETF Trends

Commodities have been slumping lately as a slowdown in China’s growth and the looming debt crisis in Europe have investors worried. Exchange traded funds and notes (ETFs and ETNs) have made commodity investing easier than ever. So, is this the time to invest before a possible turnaround?

Before you put money down, you should consider some of the risks inherent in commodity ETFs and ETNs. One main risk factor is in contango – when the front month futures contract is cheaper than second month futures contract, reports Kevin Grewal of Daily Markets.

Contago creates what is known as negative roll yield, which can potentially eat away at returns and cause tracking errors in ETFs and ETNs. Further, greater price spreads (contango) will increase the risk of underperformance. [Contango and ETFs.]

A few popular ETFs that are affected by contango are the U.S. Oil Fund (NYSEArca: USO), the U.S. Natural Gas Fund (NYSEArca: UNG) and the iPath S&P GSCI Crude Oil Ttl Ret Idx ETN (NYSEArca: OIL). [What You Can Do About Contango.]

Grewal advises that one way to mitigate the risk of contango is to utilize an exit strategy that identifies price points to sell at. Another way to mitigate the effect is, when available, use ETFs that invest across the futures spectrum and not just the front month. That would include funds like U.S. 12-Month Oil (NYSEArca: USL) and U.S. 12-Month Natural Gas (NYSEArca: UNL). [4 Commodity ETF Types.]