With the advent of exchange traded funds (ETFs), the average investor is now capable of accessing the commodities market with the click of a mouse. If there’s one thing you must understand before you start clicking, it’s the impact of contango.
Commodity ETF investors may gain exposure to the market through commodity-producing companies, funds that try to track the spot price or derivatives like futures, comments Ben Baden for U.S. News & World Report.
In the futures market, a commodity’s futures price could become higher than its current spot price, and even if the spot price of a commodity rises, an investor may still lose money. Kathryn Young, a mutual fund analyst at Morningstar, remarks that “a contango market is more likely to happen when inventories of the commodity are high because, basically, the opportunity cost of storing that commodity goes up when people don’t need it right now,” and “if inventories are very low, people are willing to pay a premium to get the commodity now.”
An ETF that holds futures contracts is going to have worse returns than the physical commodity if the market remains in contango, because the fund manager has to go in and buy a more expensive futures contract. Depending on market conditions, contango may continue for months.