Futures Contracts and ETFs
One of the primary risk factors found in futures-based commodity ETFs is contango – when the front month futures contract is cheaper than second month futures contract. If futures contracts are priced higher, or contango is present, the roll into the next month will also be priced higher, and an investor would incur a loss.
Contango creates what is known as negative roll yield, which can potentially eat away at returns and cause tracking errors in ETFs.
Your clients don’t have to take contango lying down, though. There are a number of ways to combat its effects:
- If you’re considering a fund that holds futures contracts, find out if prices are in contango. If you’re holding such a fund, do periodic check-ins to avoid getting caught off guard.
- Read the prospectus to find out how the fund works, or give the provider a call and ask. You can find the prospectus for any ETF by visiting the ETF Resume:
- If prices are in contango, look at funds the specifically seek to mitigate the effect. One option is 12-month funds from United States Commodity Funds, which invest in futures through the whole year, and not just the front months. This mitigates the effect of contango. U.S. Commodity Funds also just launched the United States Commodity Fund (NYSEArca: USCI), which selects contracts based on inventory levels, relative prices on near- and far-dated futures and one-year price momentum. PowerShares‘ futures-based commodity ETFs use an “Optimum Yield” strategy to minimize contango. This strategy involves replacing expiring futures contracts with new ones that expire in the month that will generate the highest “implied roll yield” in order to reduce contango’s impact.
- You can bypass ETFs that use futures contracts and instead look at ETFs that track commodity services companies such as SPDR S&P Oil & Gas Equipment & Services (NYSEArca: XES).
Futures-based commodity ETFs aren’t difficult to use or understand. Much like other exotic ETF types, they just need a small amount of additional research to determine whether they’re the right fit for your clients.