Countering Contango

June 03, 2006

Deutsche Bank’s bid to beat back contango could spell good news for investors. Will more funds follow suit?

Finally, someone gets it.  The commodities market has changed - at least for the time being - and index-based investment strategies must change to keep pace.

The Deutsche Bank Commodities exchange-traded fund (ETF), or DBC, has adopted a new policy designed to mitigate the impact of "contango" on shareholder returns.  Contango is the condition where out-month futures contracts are more expensive than spot prices and near-month contracts. 

To maintain consistent exposure to the commodities market, futures investors (and funds that use futures, like DBC) must periodically "roll over" their positions from contracts expiring soon to contracts expiring later.  Usually, the out-month contracts are cheaper than the near-term contracts, a situation called "backwardation." When that's the case, rolling over your contracts actually boosts shareholder returns.  But when markets are in contango, as they have been recently, funds effectively lose money when they roll over their contracts. (Note: They don't actually lose money - rather, they simply get less exposure to the commodity for their money.  But the net result for shareholders is the same.)

To mitigate the impact of contango, and to provide additional upside if they markets return to a backwardated state, DBC announced recently that it was adopting adopt a new, rules-based strategy that will allow it to select the most favorable contract when it rolls over its positions.  If, for instance, the August aluminum contract is cheaper than the July contract, it will purchase the August contract.

"The result will tend to maximize the benefits of rolling in backwardated markets and minimize the loss from rolling in contangoed markets," according to the Deutsche Bank statement.

Most commodities markets have been trading in deep contango recently, as investor demand for futures and expectations of rising prices have made out-month contracts more expensive than spot prices. DBC isn't the first commodity-based fund to realize this and tweak its strategy. The recently launched West Texas Intermediate crude oil ETF in London, OILW, from ETF Securities, uses a less sophisticated strategy with the same goal. Instead of buying the most immediate month contract when it rolls its futures contracts, it buys contracts that are priced out two-to-three months. Recently, these somewhat out-month contracts have been trading with less contango than the more immediate contracts.

The DBC strategy may be preferably, as it allows the fund flexibility to adapt to changing environments.  But its rules-based strategy is unproven, and investors may want to see it work before they embrace it.

The markets may not stay in contango forever, but while they are, these strategies will help minimize the damage done by the roll process.

Find your next ETF

Reset All