Pigs can't fly but they can contango. When investing in commodity ETFs, watch the futures curve
Exchange traded funds have revolutionised investing. Before ETFs, it was inconceivable that a retail investor - or even an institution - could directly invest in pigs or any other such commodity. Sure, they could buy farmland, slaughterhouses or meat companies - and often did. But invest in pigs as an asset class? That took commodity ETFs, often called exchange traded commodities or ETCs.
While ETCs have opened new horizons in commodities investing, commodities remain a bit different, a bit trickier. And in the land of commodity investing, not all commodities are equal. Before investing in commodities, there are some things investors ought to know. Like while pigs cannot fly they can contango.
Contango can kill you
Contango may sound like a Latin dance, but if you're investing in ETCs, it can kill you.
Our story starts with futures contracts. When issuers of ETCs track commodities, they do not go out and actually buy the commodity, except for precious metals which are easily stored. Investors do not want to buy a sty full of pigs and put them in a pen somewhere. It's impractical. With other commodities, like oil, governments will intervene to stop investors stockpiling them.
So if investors want commodities exposure, it often has to be through ETC issuers buying futures contracts, which are bought and sold on exchanges.
But futures contracts are an imperfect way to invest. Unlike shares, futures contracts cannot be held indefinitely. Futures contracts have delivery dates. And if you're left holding the can on the delivery date, the commodity -- be it pigs or oil -- could be delivered to your front door!
To avoid this, ETC issuers sell futures before delivery and buy new ones with more distant delivery dates. This process of selling near dated futures and buying further dated futures is called "rolling". It allows investors to stay exposed to a commodity via futures, without having to hold or store the commodity in question.
Rolling contracts adds another dimension - and another chance for loss or gain - to commodity investing. Thus whenever investors are looking to buy commodities, they must take into account how much the commodity costs ("the spot price", in the jargon) but also how much it will cost to roll futures contracts before they decide to sell. This is where contango and backwardation come in.
So what is contango?
As said above, futures contracts have to be rolled. Otherwise they'll be delivered.
When they're rolled, the two futures contracts - i.e. the near-dated one being sold and the further-dated one being bought - are rarely the same price.
Contango is when you're the loser in this exchange. It is when your near-dated Pig Futures Contract sells for $50, and your further-dated Pig Futures Contract costs $52 (as an example), so you lose $2 when rolling so you need the pig price to increase by $2 just to break even. In the jargon, contango is when the futures curve slopes upwards.
Contango is a problem because if you keep rolling your futures contracts in a contango market, it will whittle away any potential returns. Worse, a long contango market can undermine all the gains made from rising spot prices.
Sticking with the example, say the first Pig Futures Contract cost $47, which then rose to $50 and was rolled. That is a $3 profit. But here's the thing: the second Pig Futures Contract cost $52 -- $2 more than the first Pig Futures Contract. Contango will cost you $2, which will eat away at the $3 you made from the rising spot price, leaving you a profit of just $1 rather than $3.
Backwardation to the future
Fortunately for investors, commodity markets are not always in contango. They are often in backwardation.
Backwardation is the opposite of contango. It is when investors win. It is when the first Pig Futures Contract is sold for $52 when rolling into a second Pig Futures Contract costing only $50, meaning you make a $2 profit from the roll. This is called "the roll yield".
As a rule of thumb, if you're investing in commodities ETFs, backwardation is good and contango is bad. Investors can never be certain which way the market will go. Some futures, like pigs, wheat and natural gas are almost always in contango. Others, such as soybeans and gasoline, are often in backwardation. But as the disclaimers always say: past performance is no indication of the future.
Overcoming contango
ETCs that invest in futures cannot overcome contango. If a fund buys futures, the fund has to roll them to prevent delivery. And when the futures are rolled, the prices will usually be different. There is no escaping this.
There are, however, alternatives and ways to mitigate this.
Physical ETCs
One alternative - the most popular one - is to avoid futures altogether and leave contango at the bus stop. This can be done by buying ETCs that physically hold the actual commodity: "physical ETCs". This is only feasible and economic for certain commodities, such as precious metals, where holding the commodity is common place and governments do not mind investors hoarding it.
With gold, silver, platinum and palladium, investors overwhelmingly prefer physical ETCs. ETCs holding physical bullion are among the most popular in the world. State Street's GLD in the US and ETF Securities' PHAU in Europe, ETFs that stores gold bullion in vaults, are two of the top ETCs worldwide by assets. Other physical metals ETCs such as those storing palladium, a metal common to car catalysts, are also popular.
Rolling Strategies
If futures contracts are the only way to get exposure to a commodity, there are ways to mitigate the roll costs.
One such strategy is to buy ETCs with longer futures contracts. That way there is less rolling. "Rolling less usually improves returns," explains James Butterfill, head of research at commodities issuer ETF Securities.
"Instead of rolling every 1 month, there are longer roll strategies that usually reduce volatility and therefore give better risk-adjust returns. An index tracking futures with longer maturities can minimise the number of occasions it is exposed to a roll."
The downside of this strategy is that the longer dated price tends not to fluctuate as much as the spot price because the futures are not set to be delivered for some time. This can reduce returns expected when the spot price increase quickly.
Another, less common, strategy is called laddering. Laddering is, in effect, a kind of hedging, but for futures. It's where an ETC will buy several differently dated futures contracts, selling the most expensive and buying the cheapest. While this kind of strategy reduces the losses of contango, but the cost of hedging also means it reduces any upside from backwardation.
