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Be Aware Of Contango In Commodity ETFs

The debt crisis looming in Europe and a slowdown in China’s growth has driven commodity prices to their biggest slump since the demise of Lehman Brothers, enabling some to believe that a rally in the alternative asset class may be in the near future.   Whether or not a rally is in the near future for commodities, it is important to be aware of their inherent risks.

As the appeal of exchange traded funds (ETFs) has magnified, so has that of commodity based ETFs and exchange traded notes (ETNs).  One inherent characteristic of many commodity based ETFs and ETNs is contango.  Contango arises when the front-month futures contracts are cheaper than second-month futures contracts.  To simplify it, it is when the price of a commodity for future delivery is higher than the spot price (the opposite phenomenon occurs as well, and this is known as backwardation). 

This affects ETFs and ETNs that are futures based and/or are tracking commodity indexes such as the S&P GSCI and the DJ-AIG indexes, which typically invest their cash in just the front month futures contracts of the commodities they are tracking.  The way these ETFs are affected is that contango generates what is known as a negative roll yield.  This negative roll yield could potentially eat away at the returns of the ETF and cause tracking errors.  Additionally, the wider the spread, or “contango affect”, the higher the potential that the negative roll yield will eat away at the net asset value of the ETF.   When markets are in contango, which some argue is a normal price relationship which reflects the costs of carrying the commodity; the relative ETF will underperform its underlying commodity.

Some commonly traded ETFs that have been influenced by contango include the US Oil Fund (USO), the United States Natural Gas Fun (UNG) and the iPath S&P GSCI Crude Oil Ttl Ret Idx ETN (OIL).  As for USO and UNG, their investment goals are to follow the percentage change in the price of their respective commodities front month contract and therefore don’t always mimic the performance of their respective underlying index.

If investing in these commodity based exchange traded products, utilizing an exit strategy which identifies specific price points at which they could continue to decline in value could help mitigate the risks.

According to the latest data at www.SmartStops.net, these price points as of Friday’s market close are USO at $31.34; UNG at $7.43; OIL at $20.30.  These price points change on a daily basis as that they are reflective of market volatility and conditions.

Disclosure: No Positions

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