Exchange traded funds invested in commodities offer investors access to a traditionally hard-to-reach market, but some commodity ETFs carry contango risks and aren’t for everyone, says Michael Iachini, director of investment manager research at Charles Schwab Investment Advisory Inc.
The key, says Iachini in a Jan. 28 market insight on Schwab’s “Research & Strategies” web page, is knowing whether an ETF tracks spot or futures prices. Futures-based ETFs, the most common structure for commodity ETFs, are subject to contango and backwardation, which can make a big impact on returns.
“An ETF that holds futures contracts is going to have worse returns than the physical commodity if the market remains in contango (and better returns if the market is in backwardation),” Iachini writes. “The risk with a futures-based ETF is that contango could erode returns.”
Some ETFs hold the physical commodity itself, as is common with precious metals such as gold and silver, because storing the commodity is fairly straightforward, Iachini explains. Such ETFs will move with the spot price of the commodity, though the price could be affected by security issues around storing the physical commodity itself. Other ETFs hold baskets of futures contracts and never take possession of the physical commodity, which is the most common commodity ETF structure, whether for oil or agricultural commodities or sometimes precious metals.
When ETFs’ futures contracts get close to expiration, the ETF manager will sell the contract that is ready to expire and buy new contracts for a future date. The impact on the ETF's returns from this continuous process of selling expiring contracts and buying longer-dated contracts is called roll yield. A market in which the futures price is lower than the spot price is said to be in backwardation.
Historically, many commodities have tended to trade this way, and for those commodities, this is known as normal backwardation, Iachini notes.
“On the other hand,” he adds, “the roll yield could be negative. Let's say that the commodity's spot price is currently $50, but three-month futures contracts are trading at $52. If the relationship remains steady over time, you would be selling your maturing contracts for $50 and paying $52 to replace them with new three-month contracts. Such a market, where the futures price is higher than the spot price, is said to be in contango. Oil markets, for instance, have been in contango for quite some time recently.”
So what should ETF investors do to lessen the risk of contango?
- First, Iachini says, is to always keep in mind that the process works in investors' favor if the market for a commodity is in backwardation, Iachini says. However, if the market is in contango, consider that:
- ETFs that hold a physical commodity are not subject to contango, though such ETFs aren't available for every commodity.
- An ETF that spreads its assets among shorter- and longer-dated futures contracts will roll less of its portfolio each month, therefore lessening the impact of contango.
- Certain ETFs are constructed specifically to avoid the negative impact of contango (or to take advantage of the positive impact of backwardation) by tracking indexes that select futures contracts with the most favorable roll yield.
Read Schwab’s Iachini Argues in Favor of All-ETF Portfolios at AdvisorOne.com.