Commodity ETFs: It Takes Two to Contango

Futures-based investing has long been a popular option for those looking to gain exposure to commodities that were otherwise difficult to reach. But with the introduction of ETFs came increased granularity in this investing segment, as there are now exchange traded products that offer exposure to a wide variety of commodities through a single ticker. This alleviates the stress and complexities that are involved with managing a futures account, while allowing investors to sometimes gain access to multiple commodity futures with just one fund. Still, for everything that ETFs have opened up for the everyday investor, these funds are by no means perfect.

The biggest issue with numerous futures-based funds is contango. When futures markets are contangoed -- near-month futures are cheaper than those expiring further into the future -- the roll process can mean selling low and buying high, thereby creating some significant headwinds for investors. Exchange traded commodity products are powerful tools, but can lead to undesirable outcomes when compared to spot prices if used by those who do not fully understand the nuances of the products. The most important thing to remember about these products is that they should be thought of as a futures contract first and an ETP second. As a result, investors must realize that the contango is little more than the storage costs for a commodity by a different name, eating into returns in order to pay for these often significant costs [see also How Contango Impacts ETFs].

That being said, contango is still an issue that many ETFs deal with on a daily basis. When the underlying asset of a futures ETF -- the contracts -- are exhibiting contango, the ETF can slowly lose value over time, creating a downward pressure for as long as the contango exists. While there are numerous strategies and products that avoid contango in today's environment, the fact remains that this issue is difficult to avoid in a futures product, and investors should be aware of how their ETFs are currently behaving.

Below, we outline five ETFs currently exhibiting contango patterns for investors looking for short opportunities, or simply those looking to educate themselves on what to watch for in this budding industry. Though these products may be currently in contago patterns, investors should not take this list as a "do-not-buy-list" as the upward sloping future curve could disappear or even reverse at any time. Instead investors should take a closer look at these commodities to see if the fundamentals, as well as the contango characteristics, make for a compelling short sell, or simply a fund to avoid altogether for the time being [see also Don't Fight the Curve: Five Commodity ETFs in Backwardation].

PowerShares DB Gold Fund (NYSE: DGL  )
This product seeks to replicate a rules-based index composed of futures contracts on gold and is intended to reflect the performance of gold. As gold currently hovers near its historic high, it should be no surprise to see this product returning over 8% in 2011. But the contango currently featured in gold futures may cut into returns or erase them altogether. Gold futures are currently contangoed through June of 2015 (save one month which drops a meager dollar). As gold continues to rise DGL may well be in for a strong future, but the returns from this ETF will likely differ from spot price returns, as the contango eats away value on a monthly basis for the next four years. If gold prices sink, the contango may only compound the losses, so investors should approach DGL with caution, at least for the time being.

iPath Dow Jones-UBS Aluminum Total Return Sub-IndexSM ETN (NYSE: JJU  )
This ETN tracks an index which invests in front month future contracts on aluminum. Aluminum is an extremely popular industrial metal which, thanks to the growth of ETPs, is slowly becoming a more popular portfolio addition as investors realize that this global commodity has a good place in their base metal allocations. JJU has returned 4.5% this year for its investors, though the aluminum contracts curve may be slicing into those gains. Aluminum contracts (the only LME traded contracts on this list) are currently exhibiting contango for the next 27 months. While its important to note that contracts are not changing hands every month, when one expires, the automatic roll-over method will cause JJU to sell low and buy high -- in the current environment -- which could be bad news for this ETN. Investors looking to avoid this issue should look at FOIL, another iPath product whose methodology may help erase some of the issues of contango [see also Are Physically-Backed Metal ETFs A Good Idea?].

iPath DJ UBS Platinum Trust Sub-Index ETN (NYSE: PGM  )
PGM generates returns based on the futures contracts of one of the world's rarest metals, platinum. Thus far in 2011, this ETN has returned a steady 3.2%. For the time being, platinum futures are undergoing a period of contago that extends through January of 2012, leaving investors with a few contracts that they may want to avoid altogether. While platinum may continue to rise, the roll effect of PGM will chop off some of the gains that ETF holders may be expecting. Instead, investors have the option of investing in the platinum physically-backed PPLT, which avoids futures issues altogether by holding bars of the metal in secure vaults in Europe.

United States Natural Gas Fund (NYSE: UNG  )
This ETF consists of natural gas futures contracts and is one of the most popular ETFs available, exchanging hands nearly 12 million times daily. Natural gas is also a widely used commodity, as the energy source powers much of our home appliances (in 2009, about 25% of domestic energy was derived from natural gas). Right now, natural gas futures are experiencing contango lasting through January 2012, and with contracts trading every month until then, investors would be wise to keep up with the prices on UNG's contracts. As for alternatives, investors should take a look at NAGS, as this product's investment methodology may better combat contango in today's futures markets, as the product spreads it exposure across several months instead of just the front month contracts like in UNG [see also Three ETFs for NatGas Act 2011].

United States Oil Fund (NYSE: USO  )
USO is yet another of the most popular ETPs on market, as it is traded nearly 15 million times per day. This product measures futures contracts on light sweet crude oil (WTI), the most popular form of crude, which are currently in contango until July 2012. USO has had a hectic year alongside crude, though it has managed to scrape together gains of just under 3% in 2011. Investors should note that after the July 2012 contract expires, the contracts will slip into a backwardation period, which may make USO a good one to keep an eye on for future opportunities in trading crude oil.

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