What is ETF Contango?

Contango isn’t a latin dance move; rather, it’s when an investment drifts as compared to the underlying investment.

In recent years exchange-traded funds (ETFs) have increased in popularity. These investments are collections of shares in multiple investments, but, unlike mutual funds, ETFs can be traded fairly easily on stock exchanges. ETFs are generally low-cost, and many consider them an easy way to diversify easily while maintaining the ability to easily carry out stock-like transactions.


ETFs aren’t limited to stocks, either. There are ETFs that include a wide range of investments. You can find bond, currency and commodity ETFs without too much trouble. However, when you start getting into ETFs that contain more complex investments, such as commodities or leveraged ETFs, you run into some very interesting issues.

ETFs and Contango

Investing in commodities can provide you with diversity, and add an element of growth to your portfolio. Plus, commodity ETFs get rid of some of the complexities that come with dealing with a futures account. Commodity ETFs have made commodity investing more accessible to more people. However, the fact that these ETFs are dealing in futures means that there are some issues that need to be addressed.

Perhaps the biggest issue with investing in commodity ETFs is contango. Contango is an issue that comes into play with any investment that is futures-based. Contango is a situation in which the near-month futures are actually less expensive than those that expire later on. As a result, when the roll process is underway, it can easily result in selling low and buying high. This is a situation that investors don’t want to be in, since it means losses.

Contango becomes more obvious when investing with leveraged ETFs. Leveraged ETFs are ETFs that are designed to magnify gains or losses compared to an index. So for example, if you invest in ProShares Ultra S&P500 (SSO) it’s designed to give 2x return of the underlying S&P 500 index. The issue is this: Every day the indexing is reset since the ETF is futures based. Over time your returns do not match S&P 500 multiplied by two. Because of this, a leveraged ETF should only be used as short term (a few weeks) investment.

When it comes to commodity ETFs, contango can be an issue also. When you compare a contangoed ETF to the spot prices of the commodities involved, you might find an unfavorable situation. Over time, if the commodity contracts underlying the ETF are exhibiting contango, eventually the ETF loses value. And the situation continues — with your commodity ETF’s value being eroded — as long as there is contango in the commodities.

Paying Attention

While ETFs make it easier to invest in a variety of asset classes, using an ETF does not release you from your obligation to pay attention to what is happening with your investments. It also doesn’t release you from the obligation to understand investments before you put your money in. Before you invest in a commodity ETF — or any ETF — you should not only understand how ETFs work, but also know how the underlying investments function.

Before you invest in a commodity ETF, you should know how commodities contracts work. You should understand concepts related to the futures market. Consider ETFs as futures investments, and not just as a clever way to trade commodities as if they are stocks. It’s important that you consider the fact that, as underlying investments become more complicated, so, too, do ETFs. While ETFs can be valuable tools, and help you add diversity to your portfolio, you should remember that they are not completely safe, and investing them won’t protect you from what is happening with the underlying investments.

Comments

  1. says

    Miranda – Excellent write up! Commodity and leveraged ETFs can be valuable investing tools but it is crucial to understand how they work and how to mitigate their weaknesses when using them. Thanks for getting the word out.

  2. Dan says

    The problem with levered ETFs has nothing to do with contango, it has to do with the path dependence of compounding of *DAILY* leveraged returns, which is what the levered ETFs target.

    Assume the market drops 5% one day and rallies 5.2632% then next. If you start with $100 you are now back to your starting value 100(.0004 due to rounding). If you have a 2x (remember 2x daily return) ETF you lose 10% the first day, so $90, then make 10.5264% the next day to end the 2nd day with $99.47. This “tracking error” builds over time and is much worse on 3x fund (you’d end the 2nd day with $98.42) or in high volatility sideways markets (the chop kills).

  3. says

    I’m a little confused here – index futures (ES, YM etc) don’t really experience contango – at least I’ve never seen it. Instead they have backwardation like you would expect based on zero risk rate and underlying dividend rate. They typically have a nice smooth drop in price in the forward months like this:
    http://www.cmegroup.com/trading/equity-index/us-index/e-mini-sandp500.html

    In the context of commodities, sure, contango (and cost of carry in general) can be an issue.

    • says

      Any ETF that is futures based can have contango. Pure index based funds (which aren’t futures/derivatives based), can also but much less likely. It depends upon their indexing strategy. I always thought to create an index fund/ETF was simple, it is not. There are different methods to replicate an index and can make a fund for example slightly more tax efficient.

      Which then goes back to Dan’s statement above, so I believe my statement about leveraged ETFs is still technically correct because they can experience contango just from one full day of trading. They also have tracking error as well.

      If anyone spots technical errors in the post, I can/will correct them and the reason for my discussion of the topics.

      • Dan says

        Stock index futures don’t generally experience contango, because there is no real cost to carry aside from the time value of money and loss of potential dividends. If you look out the curve on ES for example you’ll see the further out contracts be lower priced by approximately the risk free rate of return plus expected dividends, or slight backwardation (6.5 or so pts right now, so 4 quarters 26 pts, or 1.9%, pretty close to the dividend yield because the risk free rate is essentially 0 right now). I’ve never seen ES in contango, also there’s no reason for an ETF leveraging daily returns to focus on anything but the front month in ES, non-front month in ES has a pittance for volume and it’s really no different than the back month when you factor out dividends and carry.

        Commodities markets exhibit contango generally due to to storage costs. That difference is payed by the ETFs that hold commodity futures when the roll them. Also the VIX futures are frequently in contango as people overestimate the likely-hood of extreme outcomes, hence VXX is a bad long term buy and hold candidate.

        Let’s assume oil is in contango .. front month or spot trading at $100, and s 3 months out at $105 (currently contango between months in the CL contract is more like $0.35). One has to assume it costs $5 to store $100 worth of oil for 3 months, otherwise there’s an arbitrage opportunity buying up the physical/front month vs selling the 3 month forward and capturing that $5 today and store the oil until making delivery.

        • says

          I think you’re spot on, Dan. The only thing I would add is the delivery arbitrage also technically involves borrowing the money to buy the physical/front month and then repaying it after making delivery. At the moment that makes next to no difference (what with 0% rates and all) but in higher rate environments it matters.

      • says

        It’s not so much an error as I’ve just never seen a situation where forward months on an index future trade at a premium to the front month. And I trade the index futures on a daily basis so I would kind of expect to notice. I’m not saying it can’t happen – I’d have to think about that a lot before commenting. But it’s certainly not the normal state of affairs.

        I believe the failure to track for leveraged index ETFs stems from their borrowing costs and re-balancing slippage (when prices go down, they have to engage in a fire sale to keep leverage at X:1), not from contango – simply because there isn’t any.

Leave Your Comment Below

*