Investor Junkie
MENUMENU
  • Start Investing
    • HOW TO GET STARTED INVESTING

      New here? Just starting as an Investor?

      If you're a new investor and visiting Investor Junkie for the first time, then this is what you need to get started.

    • GETTING STARTED STEPS

      • Get Rid of Consumer Debt
      • Start ​​​​​​​Investing Now
      • Open a Retirement Account
      • Create an Asset Allocation
      • Minimize Taxes
      • Reduce Fees & ​​​​​​​Fund Expenses
      • Start a ​​​​​​​Side Hustle
      • Protect ​​​​​​​Your ASSets
      • Next Steps
  • Reviews
      • Recommended Services

      • Personal Capital
      • Betterment
      • YNAB
      • Acorns
      • Fidelity Investments
      • Ally Invest
    • Robo Advisors

      • Betterment
      • Wealthfront
      • Wealthsimple
      • Blooom
      • More Reviews

      Stock brokers

      • Ally Invest
      • E*TRADE
      • Merrill Edge
      • TD Ameritrade
      • More Reviews
    • Microsavings

      • Acorns
      • Digit
      • Stash Invest
      • Qapital
      • More Reviews

      Banking

      • Ally Bank
      • CIT Bank
      • Chime
      • EverBank
      • More Reviews
    • Personal Finance

      • Mint
      • Quicken
      • Personal Capital
      • YNAB
      • More Reviews

      Accounting

      • FreshBooks
      • QuickBooks
      • Sage Business Cloud Accounting
      • Wave
      • More Reviews
    • Real Estate

      • Fundrise
      • Realty Mogul
      • RealtyShares
      • PeerStreet
      • More Reviews

      Peer-to-Peer Lending

      • Lending Club
      • Prosper
      • Wunder Capital
      • YieldStreet
      • More Reviews
    • Investment Research

      • Barron’s
      • Morningstar
      • Stansberry Research
      • YCharts
      • More Reviews

      Financial Books

      • Rich Dad, Poor Dad
      • Money Master The Game
      • The Millionaire Next Door
      • The Best Finance Books
      • More Reviews
  • Compare
    • Robo Advisors

      • Betterment vs. Wealthfront
      • Betterment vs. Vanguard
      • Wealthfront vs. Vanguard
      • Wealthfront vs. Wealthsimple
      • Compare Others
    • Personal Finance

      • Quicken vs. Mint
      • Mint vs. Personal Capital
      • Mint vs. YNAB
      • Quicken vs. Personal Capital
      • Compare Others
    • Stock Brokers

      • Schwab vs. Fidelity
      • E*TRADE vs. TD Ameritrade
      • E*TRADE vs. Robinhood
      • Fidelity vs. Vanguard
      • Compare Others
    • Real Estate

      • Fundrise vs. Realty Mogul
      • Realty Mogul vs. RealtyShares
      • Fundrise vs. Rich Uncles
      • LendingHome vs. PeerStreet
      • Compare Others
    • Banking

      • Best Online Savings Account
      • Best Online CD Rates
      • Best Jumbo CD Rates
    • Peer-to-Peer Lending

      • Lending Club vs. Prosper

      Microsavings

      • Acorns vs. Stash
  • Learn
      • All Articles
      • Investing SecretsInvesting Secrets
      • The Mint ManualThe Mint Manual
      • SEE ALL ARTICLES
    • Budgeting

      • How Much Do I Need to Save per Month
      • What is Zero-Based Budgeting?
      • 50/30/20 Budgeting Doesn’t Work
      • Why I’ve Switched to Personal Capital
      • See All

      Robo Advisors

      • Robo-Advisor Overview
      • True Costs of the Robo-Advisors
      • Robo-Advisors vs. Target Date Funds
      • Robo-Advisors vs. Microsavings
      • What is Tax-Loss Harvesting
      • See All
    • Investing

      • How to Choose an Online Broker
      • How to Transfer to a New Broker
      • Invest Your First $1,000
      • Who Offers a Virtual Trading Account?
      • See All

      Real Estate

      • Investing in Real Estate
      • 3 Steps to Get Started as a Real Estate Investor
      • You’re a Fool to Prepay Your Mortgage
      • How to Use Your 401(K) as a Down Payment
      • Tax Lien Investing
      • See All
    • Retirement

      • How to Rollover a 401(K)
      • How to Maximize Your 401(k)
      • Target Date Funds Comparison
      • Roth IRA vs. Traditional IRA
      • See All

      Taxes

      • 2017 Retirement Plan Contribution Limits
      • Tax-Efficient Investing
      • Tax-Loss Harvesting
      • How to Pay $0 Tax on a Six-Figure Income
      • The Best Tax Software for Investors
      • See All
  • Promotions
    • Featured promotion
      Betterment

      Betterment

      BEST OFFER
      Up to one year managed free initial deposit

      Learn More
    • Stock Brokers

      • Ally Invest
      • E*TRADE
      • Firstrade
      • Merrill Edge
      • TD Ameritrade

      Best IRA Promotions

      Free Stock Trading

    • Robo Advisors

      • Betterment
      • Blooom
      • Wealthfront
      • Wealthsimple
      • Ellevest
    • Personal Finance

      • Quicken
      • QuickBooks
      • YNAB
    • Microsavings

      • Rize
      • Stash Invest
      • Acorns
    • Other

      • Lending Club
      • Roofstock
      • RealtyShares
      • YCharts
      • Personal Capital
Home > Investing > What Is ETF Contango?

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.

Share4
Tweet9
Share1
Reddit1
Email

Author: Miranda Marquit
Updated: September 29, 2017
Category: Investing

So You Want to Learn About Investing?

Sign up for our 7-day email series (it's free) and learn the building blocks you need to start investing today.
Signup to Learn Investing

Suggested For You

  • secret

    23 Financial Experts Share Their Best Investing Secret For Beginners

    Wouldn’t you want to know the best investing secret from some of the smartest financial experts in the world? Well you’re in luck! We asked over 20 investing experts to share their best investing “secret” for anyone just getting started with investing. […]

  • Never invest in assets

    What to Look for in an ETF

    The exchange-traded fund (ETF) industry is growing at a dizzying pace as new funds are made available to investors each week. The growth in the industry doesn’t come without its growing pains – investors have to carefully look through available ETFs to find one that will work for their investment objectives. […]

  • Commission-Free ETFs

    Commission-Free ETFs

    Exchange-trade funds (ETFs) can be effective investments... but a bit on the pricey side. The solution? Here are some commission-free ETFs on offer right now.

Comments

Notify of



Sort by:   newest | oldest | most voted
W-at-Off-Road-Finance
6 years 2 months ago

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.

0
 |     Reply   Hide Replies ∧
Larry Ludwig
6 years 2 months ago

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.

0
 |     Reply   Hide Replies ∧
W-at-Off-Road-Finance
6 years 2 months ago

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.

0
 |     Reply   Hide Replies ∧
Dan
6 years 2 months ago

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.

3
 |     Reply   Hide Replies ∧
W-at-Off-Road-Finance
6 years 2 months ago

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.

1
 |     Reply   Hide Replies ∧
Dan
6 years 2 months ago

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).

1
 |     Reply   Hide Replies ∧
Larry Ludwig
6 years 2 months ago

Hi Dan,

Ut Oh Rogie. I was the one who added that to the post. Did I make a mistake about leveraged ETFs? My understanding was they reset only because of the pricing on the underlying futures reset daily. If not, then why are leveraged ETFs reset daily? What’s the purpose?

0
 |     Reply   Hide Replies ∧
Dan
6 years 2 months ago

Here’s the math:
https://seekingalpha.com/article/113020-understanding-levered-etfs-and-geometric-returns

and more:
https://seekingalpha.com/article/193431-leveraged-etfs-understanding-the-risks-and-strategies

0
 |     Reply   Hide Replies ∧
Larry Ludwig
6 years 2 months ago

Thanks Dan for the info.

0
 |     Reply   Hide Replies ∧
Dan
6 years 2 months ago

I think I addressed most of your comments here in the reply I put below your comment to W-at-Off-Road-Finance.

But to sum it up, the fundamental reason levered funds lose value is because the path of non-zero % losses and gains that eventually lead you somewhere, won’t get you there if you simply multiply them all by 2 or 3 it’ll get you lower.

Here’s the jist:

Series: +2%, -2%, +5%, +5%, -10%

Normal:
100 * 1.02 * .98 * 1.05 * 1.05 * .9 = 99.19

2x Leverage
100 * 1.04 * .96 * 1.1 * 1.1 * .8 = 96.6

Note that the ETFs also have an actual tracking error, the generally don’t hit their target return exactly, and it’s usually not in the investors favor.

0
 |     Reply   Hide Replies ∧
Dan
6 years 2 months ago

Obviously if you get a completely 1 sided move with no retracements you’ll do exceedingly well with a levered ETF, but the “random walk” that markets take guarantees you’ll lose money in levered funds over the long term.

0
 |     Reply   Hide Replies ∧
Ken Faulkenberry
6 years 2 months ago

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.

0
 |     Reply   Hide Replies ∧
wpDiscuz

Recent Investing Articles

What Investment Can Get Me Rich Quick? How Teens Can Start Investing Right Now Investing As an Expat – What You Need to Know What Is Short Selling Stocks? Should I Do It? What Is Socially Responsible Investing?

Popular Articles

  • Personal Capital Review
  • Betterment Review
  • Betterment vs. Wealthfront
  • Acorns vs. Stash
  • Wealthfront Review
  • Overview of Robo-Advisors
  • Aly Invest Review
  • Mint Review
  • Quicken 2018 Review
  • Stash Invest Review
  • YNAB Review
  • Acorns Review
  • TD Ameritrade Promotional Codes

Investor Junkie

Helping make finance easy. Investor Junkie is your shortcut to financial freedom. We know that managing finances is not easy. We analyze and compare tools to help you make the best decisions for your personal financial situation.

© 2018 Empowering Media, Inc. All Rights Reserved
Subscribe to the Investor Junkie Newsletter
  • About
  • Careers
  • Contact
  • Advertise
  • Privacy
  • Disclaimer

Stay Connected to Investor Junkie

  • subscribe unsubscribe

Investor Junkie is a financial publisher that does not offer any personal financial advice or advocate the purchase or sale of any security or investment for any specific individual. Members should be aware that investment markets have inherent risks, and past performance does not assure future results. Investor Junkie has advertising relationships with some of the offers listed on this website. Investor Junkie does attempt to take a reasonable and good faith approach to maintaining objectivity towards providing referrals that are in the best interest of readers. Investor Junkie strives to keep its information accurate and up to date. The information on Investor Junkie could be different from what you find when visiting a third-party website. All products are presented without warranty. For more information, please read our full disclaimer.