If your clients are looking for exposure to commodities in their portfolios, exchange traded funds (ETFs) are an easy way to get it without the hassle of buying and/or rolling futures contracts.
What Are Futures?
Futures, as they relate to commodities, are contracts between two parties.
Let’s use wheat as an example. Someone purchasing a December futures contract for wheat is locking in the current price of that contract, while the person selling such a contract is saying that they will deliver wheat at the price for which the futures contract was purchased.
As December approaches, one of three things usually happens:
- Roll the contract and purchase another one for a later date
- Take delivery of the wheat
- Settle the contract for cash
A majority of the futures contracts traded on the exchange floor are settled or swapped for cash before the expiration date.
Speculators – those investing for profit – don’t usually want to take delivery; they’ll often own futures contracts in order to profit from rising commodity prices. For that reason, they want to sell before the contract expires to avoid the awkward situation of having a few tons of wheat show up on their doorstep.
Not everyone who owns futures has the same objective. For instance, a farmer would use futures to lock in a price for a commodity or livestock to reduce risk, or hedge. Airlines often hedge rising fuel prices by purchasing futures contracts.
ETF investors, however, usually just want to play rising commodity prices. And with commodity prices the way they’ve been recently, now is a great time to learn about the various ways this can be spun into an advantage.
Backwardation and Contango
ETFs that own futures contracts always roll those contracts forward; they never take delivery. Contracts in ETFs are sold to someone who will take delivery of the commodity in exchange for a contract that has a date that’s further out.
But depending on the makeup of the commodity’s futures curve, rolling futures contracts may create profit or loss for the ETF.
That’s because commodity markets are always in a state of backwardation or contango.
- Contango is when the futures price is higher than the spot price.
- Backwardation is when the futures price is lower than the spot price.
ETFs that own futures can lose money when they roll to more expensive contracts as the cheaper ones expire, which eats into returns.
As a result, many ETFs have sought to mitigate this negative effect. Two popular ways to do this are:
- Roll to the most advantageous month. PowerShares utilizes this strategy in its futures-based commodity funds, such as PowerShares DB Oil (NYSEArca: DBO). The Optimum Yield strategy replaces expiring contracts with newer ones that will generate the highest “implied roll yield,” which helps mitigate the negative impact of contango.
- Minimizing how often contracts are rolled. Teucrium just launched Teucrium Natural Gas (NYSEArca: NAGS), which rolls contracts four times a year, so turnover is limited to 100%. Funds that roll every month sends turnover up to 1,200%, which can be painful if the market is locked in contango.
Of all the commodity ETF types, futures-based may require the most understanding. How an ETF rolls its contracts, when it rolls contracts and whether the underlying commodity is in a state of contango or backwardation will have an impact on your returns.
While commodity ETFs have vastly simplified the ways ordinary investors can get exposure to strategies previously unavailable to them, they still require some measure of understanding and education. Not knowing the ins and outs of this market can be costly if you’re not careful.