One of the most popular and commonly used commodity exchange traded fund (ETF) types are those that hold and trade futures contracts for the underlying commodity. Before you start allocating these types of funds to your clients’ portfolios, however, it’s worth understanding how they work. Failing to do so could leave you feeling burned.
Futures are a promise to buy or sell a commodity for a set price on a date that’s in the near future. None of the ETFs that hold futures contracts claim to track the spot price of their respective commodities.
An ETF provider will sell a futures contract as the contract comes close to expiration so that they may avoid having to deal with the actual delivery of the physical commodity. Fund providers would buy the next month’s contract, or “roll” the commodity, and repeat the action every month.
Futures add a time component to the price: when tomorrow’s cost is higher than today’s, it’s called contango; the inverse called backwardation. Investors should note that some ETFs have blind front-month roll strategies, but most ETFs now buy futures months in advance.