Commodity ETFs: A guide to contango and backwardation

There are a number of different ways that ETFs provide commodity exposure to investors.

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Without a doubt, exchange-traded funds have revolutionized the way investors buy and sell commodities, but not all ETFs are created equal. There are a number of different ways that ETFs provide commodity exposure to investors, and in this article, we explain one popular method.

Certain commodities out there are easy to buy; for others, that's far from the case. Gold, for example, is easy enough to purchase and store—whether it be in your house or in a vault. And many ETFs take advantage of that fact by holding physical gold.

On the other hand, commodities such as wheat, natural gas, or crude oil are almost impossible for the average person—or even an institution—to get their hands on. That's why many exchange-traded funds turn to the futures market to get exposure to these markets.

But while investing in futures may be the most accessible route into these markets, it’s an imperfect one. In particular, investors must understand the 3 sources of return when it comes to futures.

The first is simply the spot price. This is the most straightforward component of returns. If oil rises from $100/barrel to $110, that is profit for an investor. If the story ended there, that would be great, and investors would receive near-perfect exposure to oil prices; but it doesn't.

Next is the roll cost or the roll yield. Unlike a stock, you can't simply hold a futures contract indefinitely. They all have an expiration date, and an ETF must "roll" from one contract to the next before expiration. Typically, each contract on the futures "curve" is priced differently based on the number of days until expiration, as well as a number of other factors.

If each subsequent month on the futures "curve" is priced higher than preceding months, a commodity is said to be in contango. The opposite situation—when subsequent months are priced lower than preceding months—is called backwardation.

These concepts are extremely important when it comes to investing in exchange-traded funds that use futures for their commodity exposure. An ETF that employs a basic strategy of investing in the front-month futures contract of a given commodity, for example, will either see its returns decrease in the case of contango or increase in the case of backwardation.

In a hypothetical situation, an ETF may be holding front-month WTI (West Texas Intermediate) crude oil contracts worth $100/barrel. Before expiration, that ETF may sell those contracts and purchase second-month futures contracts for $101. The ETF will be able to buy nearly 1% less crude oil because of the higher price—a loss for investors.

These roll costs can be substantial. A 1% monthly cost comes to a nearly 13% cost on an annualized basis. That could wipe out any gains in the spot price, or similarly, exacerbate any losses in the spot price.

However, the rolling phenomenon isn't always a negative for investors. As we wrote earlier, backwardation actually aids investors' returns. If in the above example, an ETF holding $100 crude oil was able to roll its contracts into $99 crude, the fund would be able to buy more contracts than it originally had, increasing investors' returns.

That brings us to the third and final component of futures returns—interest income. Futures are leveraged products, meaning that investors only need to put a portion of a contract's full value down as collateral. ETFs typically use the rest of the money to invest in safe, short-term securities, such as T-bills. During periods of low interest rates, the additional returns from interest income are negligible, but when rates are higher, they can have a notable impact.

During the 1980s, for example, when rates were in the double-digit range, interest income provided investors with hefty returns despite falling spot prices in commodity markets.

In contrast, in the period following the 2008 recession, interest income has added virtually nothing to investors' returns, and movements in spot prices and the shape of the futures curve (contango/backwardation) are much more important.

Managing contango

It's important to point out that indexers or active fund managers have a choice about which contracts to buy when they’re trying to access a commodity. Conventional wisdom is that buying the front-month will more closely track spot prices, but there are ETFs that explicitly alter this approach in an attempt to avoid contango or profit from backwardation, with varying levels of complexity—and success. Make sure you understand an ETF's approach to this before jumping in.

Next steps to consider

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