- Investors must keep in mind that most of their commodity-related ETFs do not track the spot price
- However, there are some exceptions, including precious metals-related exchange traded products
- Futures market may diverge from the spot price due to a number of factors, including storage costs and seasonal patterns
With commodity exchange traded funds gaining traction as raw materials prices are on the mend, it is important for investors to keep in mind that most of their commodity-related ETFs do not track the spot price.
Most commodity ETFs do not track the spot price, or commodity prices as investors see them in the headlines. However, there are some exceptions, including precious metals-related exchange traded products that are backed by physical gold, silver, platinum and palladium bars stored in bank vaults.
Most commodity ETFs track futures contracts. The futures market may diverge from the spot price due to a number of factors, including storage costs and seasonal patterns, among others. Consequently, investors would be exposed to the intricacies of the futures market, which may not perfectly reflect the spot price returns of the underlying commodity.
Specifically, investors will have to watch for roll returns or roll yields. Since the commodity ETFs hold futures contracts, these ETFs avoid physical delivery before a contract expires by rolling the contract or buying a new contract with a later maturity date.
“This is where spot and futures returns start to differ,” writes James de Bunsen, multi-asset fund manager at Henderson Global Investors, for the Financial Times.
The futures curve, or what you see when you plot each month’s contract against its price, is often upward sloping, or known as “contango.” If the futures market is in contango, a commodities contract that is set to expire will cost less than later dated contracts.
For instance, many would likely turn to the U.S. Oil Fund (NYSEArca: USO), which tracks West Texas Intermediate crude oil futures, to play a turn in the energy market. Oil traders, though, should be aware that USO tracks front-month WTI future contracts and the underlying oil market is currently in a state of contango – WTI crude oil for April 2016 delivery is trading at $37.26, whereas WTI contracts for March 2017 is hovering around $43.44, according to the CME Group. Consequently, USO could experience a negative roll yield when rolling a maturing futures contract, or selling a contract that is about to expire in exchange for the next month contract.
“Curves in contango mean the passive ETP investor is selling low and buying high every month as futures are rolled,” de Bunsen said, referring to exchange traded products, which include both ETFs and exchange traded notes.
On the other hand, if the futures market is in backwardation, the contract that is set to expire costs more than later-dated contracts. Consequently, it would be in the best interest of a futures-based ETF investor to limit the negative effects of contango and capitalize off backwardation as the ETFs roll contracts set to expire for a later-dated contract.
“This is why investors should take a view on the futures curve as well as the spot price when buying bulk commodity ETPs,” de Bunsen added. “And if the curve is upward sloping it probably means the best trades will be those that anticipate short, sharp upward moves in spot prices so that the negative roll costs don’t offset those returns over time — or compound losses if the call happens to be wrong.”