Exchange-traded funds are some of the most useful investments ever created. But they can also be more complicated than you realize, and if you don't understand all the intricacies involved in a particular ETF, you can inadvertently walk into a trap where the odds are stacked against you. An obscure phenomenon called contango is one risk that plagues exchange-traded products that rely on futures contracts.
In certain areas, including natural resources and volatility-tracking indexes, the easiest way for ETFs to track their respective benchmarks is to use futures. Yet when futures are in a state of contango, the rules that these ETFs follow make some of them prone to lose money slowly but steadily over time, while others actually benefit from the phenomenon. Let's take a closer look at the biggest risk facing futures-based ETFs and how to tell whether you're at risk.
Contango has a strange name, but the idea behind it isn't that hard to understand. Futures contracts give investors the right to claim delivery of a certain commodity at a fixed point in the future. But most investors don't actually take delivery of the commodity, instead closing their futures positions on the open market before the contract expires. Often, investors who want to maintain their positions will simply roll them forward to the next month's contract.
That strategy works seamlessly if the prices for futures contracts in both months are the same. But in many markets, you'll pay a different price depending on when you want the commodity. If the price of a soon-to-expire futures contract is less than the price of a longer-dated futures contract, then the market is said to be in contango. If the reverse is true, then the market is in a state called backwardation.
The reason that contango is bad for certain ETFs is that if you're constantly paying higher prices every single month to replace your expiring contract with the next month's futures contract, you'll slowly but surely lose money in relation to the movement in the spot price of the commodity.
Two big examples
Contango is easier to understand by looking at examples, and the most obvious one is natural gas. The United States Natural Gas ETF (NYSEMKT:UNG) has lost a huge portion of its value over the past several years. At first glance, that makes complete sense, as natural-gas prices have fallen sharply over the same time period. But when you look at the ETF, you'll find that it has lost far more of its value than spot gas prices would suggest. Contango is the culprit.
Looking at current natural gas futures, the April contract currently trades at a price that's nearly $0.05 below the May contract. That may not seem like much, but it represents almost 1.5% of the contract's price at the moment. When the ETF rolls its futures contracts forward to the next month, the price is tied to that higher amount.
If the futures price accurately reflects what the spot price will be in May, then spot gas investors will enjoy a $0.05 gain in value for their natural gas holdings. But the ETF will miss out on those gains, losing 1.5 percentage points of return. Conditions aren't that bad every month, and sometimes nat-gas has been in backwardation. But over the years, contango has ravaged the ETF's relative returns.
How volatility works against you
You can see the same phenomenon in the volatility-tracking iPath S&P VIX ST Futures (NYSEMKT:VXX) and the related leveraged VelocityShares Daily 2x VIX ST (NASDAQ:TVIX). Currently, the March VIX futures contract trades at a level of 16.39, but the corresponding April contract is at 16.91, more than 3% higher. As a result, ETFs that use a monthly roll-forward strategy currently face headwinds of 3 percentage points per month against their return.
But for inverse ETFs, contango can actually help. The VelocityShares Daily Inverse VIX ST ETN (NASDAQ:XIV) has soared over the past year, largely due to low volatility. But because of its inverse orientation, contango has worked to the ETN's benefit, providing a boost to monthly returns.
Don't do the contango
As convenient as ETFs are, they can be traps for the unwary. When you're considering buying an ETF that uses futures contracts, be sure to look at the underlying conditions in that futures market to make sure contango won't ravage your returns over the long haul.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.