ETF Univ: A Guide To Contango & Backwardation

June 01, 2020

ETF UNIVERSITY

Without a doubt, exchange-traded funds have revolutionized the way investors buy and sell commodities. There are a number of different ways ETFs provide commodity exposure to investors, but futures contracts are a particularly popular method.

Commodities such as wheat, natural gas and crude oil are almost impossible for the average person—or even an institution—to get their hands on. That’s why many ETFs turn to the futures market to get exposure to these markets.

Returns & Spot Price
While investing in futures may be the most accessible route into these markets, it’s an imperfect one. In particular, investors must understand the three sources of return when it comes to futures.

The first is simply the spot price. This is the most straightforward component of returns. If oil rises from $100/barrel to $110, that’s profit for an investor. If the story ended there, that would be great, and investors would receive near-perfect exposure to oil prices; but it doesn’t.

Understanding Roll Costs
Next is the roll cost, or the roll yield. Unlike a stock, you can’t simply hold a futures contract indefinitely. They all have an expiration date, and an ETF must “roll” from one contract to the next before expiration. Typically, each contract on the futures “curve” is priced differently based on the number of days until expiration, as well as a number of other factors.

If each subsequent month on the futures “curve” is priced higher than preceding months, a commodity is said to be in contango. The opposite situation—when subsequent months are priced lower than preceding months—is called backwardation.

These concepts are extremely important when it comes to investing in ETFs that use futures for their commodity exposure. An ETF that employs a basic strategy of investing in the front-month futures contract of a given commodity, for example, will either see its returns decrease in the case of contango, or increase in the case of backwardation.

In a hypothetical situation, an ETF may be holding front-month WTI crude oil contracts worth $100/barrel. Before expiration, that ETF may sell those contracts and purchase second-month futures contracts for $101. The ETF will be able to buy nearly 1% less crude oil because of the higher price—a loss for investors.

These roll costs can be substantial. A 1% monthly cost comes to a nearly 13% cost on an annualized basis. That could wipe out any gains in the spot price, or similarly, exacerbate any losses in the spot price.

However, the rolling phenomenon isn’t always a negative for investors. Backwardation actually aids investors’ returns. If in the above example, an ETF holding $100 crude oil was able to roll its contracts into $99 crude, the fund would be able to buy more contracts than it originally had, increasing investors’ returns.

Interest Income
That brings us to the third and final component of futures returns—interest income. Futures are leveraged products, meaning investors only need to put a portion of a contract’s full value down as collateral. ETFs typically use the rest of the money to invest in safe, short-term securities, such as T-bills. During periods of low interest rates, the additional returns from interest income are negligible, but when rates are higher, they can have a notable impact.

During the 1980s, for example, when rates were in the double-digit range, interest income provided investors with hefty returns despite falling spot prices in commodity markets.

In contrast, in the period following the 2008 recession, interest income has added virtually nothing to investors’ returns, and movements in spot prices and the shape of the futures curve (contango/backwardation) are much more important.


SELECTED TERMS

Bid/Ask Spread
ETFs trade like single stocks, so bid/ask spreads are a part of daily life for an ETF. The spread is simply the difference between the price someone is willing to pay for an ETF (the bid) and the price someone is willing to sell that ETF for (the ask). The most important takeaway here is that the wider the spread, the more expensive it is to trade that ETF. That’s why we list the “average spread” for all ETFs in our fund pages (etf.com/ticker) along with other crucial data points such as expense ratio, assets under management and average daily volume. This metric should be part of your ETF due diligence if costs are important to you.

Contango/Backwardation
These are terms seen across the commodity ETF space. They pertain to roll costs associated with moving from one futures contract to another. When an expiring futures contract is cheaper than—or trading at a discount to—the next month’s contract, the futures curve is in contango. Contango translates into roll costs to an investor (or an ETF) having to move from one contract to the next. The opposite of contango is backwardation, when the expiring futures contract is trading at a premium to the next contract. Contango and backwardation impact commodity futures and futures-based ETF returns. Many commodity ETFs try to optimize their roll strategy to circumvent the impact of contango on returns.

Grantor Trusts
One of the most commonly used structures for commodity ETFs, a grantor trust is a physically backed trust that stores the physical commodity— say, gold or silver bars—in vaults while giving investors exposure to spot returns of that commodity. The biggest example of a grantor trust is the SPDR Gold Trust (GLD). By owning shares of GLD, ETF investors actually have claim to physical gold being vaulted in London.

Tracking Difference/Tracking Error
Most ETFs are designed to track an index. Tracking difference, simply put, is the disparity between the returns of an ETF and the performance of the underlying index it tracks. In a perfect world, an index-based ETF would deliver exactly the performance of the index minus its fees (the expense ratio). But other factors can contribute to tracking difference, such as trading and rebalancing costs, as well as tracking methodologies that differ from the original benchmark, among other things. Tracking difference is not to be confused with tracking error, which is a measure of how volatile the performance difference between an ETF and its index is—the standard deviation—on an annualized basis.

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