Word Of The Day: Contango

One of the terms you hear frequently when reading about commodity ETFs, is the word “contango.”

To enhance your understanding of what it means and how it affects ETFs, here are some highlights from “Contango and ETFs: What It Is, What You Can Do About It:”

Investors love commodity exchange traded funds (ETFs), and with good reason. Aside from the usual benefits that ETFs offer, commodity funds deliver

the kind of exposure to commodities that would otherwise be very challenging, very expensive or both. But not all commodity funds are created equal, and one of the most important types to understand are those that hold futures contracts.

One of the most popular commodity ETF types are those that hold and trade futures contracts for the underlying commodity. Futures are a promise to buy or sell a commodity for a set price on a date that’s in the near future. None of the ETFs that hold futures contracts claim to track the spot price of their respective commodities.

The majority of these funds buy the near-month contract, selling it before expiration and buying the next month’s contract, and so on. If the price of the next month’s contract is higher than the current month’s, it’s a situation called contango, and it could cost you money when the contracts are rolled over. A negative roll yield (contango) could cause the net asset value (NAV) of a fund to deviate even further from the spot price of its underlying commodity. The opposite situation is backwardation.

One way to mitigate the effects of contango is to look for ETFs that hold contracts throughout the year. There are just two such funds now: United States 12-Month Oil (NYSEArca: USL) and United States 12-Month Natural Gas (NYSEArca: UNL).

The purpose of a 12-month strategy will help protect futures investors from the problem of contango. Two weeks before the expiration of the nearest-month contract, the fund will roll forward another month, picking up the then-12-months-out contract.

[Emphasis added]

While contango is not something you as an ETF investor will have to worry about, if you stick to non-commodity ETFs, it’s nevertheless a term that you need to be familiar with should you decide to venture into the commodity arena.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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