ETFs, Contango, Why Commodity ETFs Don't Always Correlate With Underlying Prices

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Last week a colleague forwarded me an article from BusinessWeek discussing the role of contango as it applies to ETFs. (Don’t worry – this won’t be a technical piece). In layman’s terms, the article examined how an underlying commodity price could increase whereas an ETF, invested in that same commodity, could go in the opposite direction. Hence investors have lost money by investing in the commodity ETF. The article suggests the issue involves a situation called contango. Contango refers to a futures price that is more expensive than the spot or near term contract price. For the most part, most metals trade in contango (in fact, we just recently reported that tin flipped and moved to backwardation the opposite of contango or rather when the spot price exceeds its futures price). Based on our analysis, the problem with ETFs is not so much due to contango per se, but rather when the funds futures contracts expire – they may have to purchase new futures contracts at higher prices. The same argument can be made for anyone buying futures contracts so the potential problem is not unique to ETF’s.

What is unique to ETF’s however, and subject to the controversy outlined in the BusinessWeek article (namely that some investors have lost money in ETF’s even as underlying commodity prices have increased) is that fund managers can only replace those futures contracts during the “roll period (that is, a set number of days that the funds can purchase futures contracts). And lo and behold, the prices for those futures contracts tended to go up whereas the futures contracts fell in price after the roll period. And other futures traders, according to the BusinessWeek article can “buy the next month ahead of the big programmed rolls to drive up the price or sell before the ETF pushing down the price investors get paid for expiring futures. This results in the fund essentially under-performing the actual market, particularly if it needs to re-purchase futures contracts at higher prices.

So how big of an issue is this? Well, that would certainly depend upon which commodities one has investments in and which ones are subject to these futures contracts. MetalMiner has tracked over 30 ETF’s considered to be part of the “metals space. But in actuality, only a couple of metals funds actually play in the futures markets. The first involves aluminum: the iPath Exchange Traded Notes Dow Jones – UBS Aluminum Total Return Sub-Index ETN Series A and the second, copper. Most of the other metals ETFs track to a sub-index off the futures markets but don’t actually take futures positions. We should note that platinum group metals ETF’s are actual physically backed ETF’s meaning the metals are actually warehoused.

Another interesting phenomenon that metals-based ETF investors will want to pay heed to involves the launch of physically backed ETFs. Both Glencore and Credit-Suisse have announced plans to create two physically backed ETFs to be launched still within this year. We will wait to see if either of these two funds actually come to fruition. Meanwhile, Goldman Sachs owns a global network of aluminum warehouses. The physically backed ETFs offer some risk protection in the sense that the funds can take delivery of material when they want and choose to do so and avoid the game of the “roll contracts.

MetalMiner has previously published a three part series on metals based ETFs. You can read those posts here:

A Primer On Base Metal ETFs

The Role of ETFS or ETNs on Base Metal Prices

Can ETF Commodity Backed Funds Be Used For Hedging

–Lisa Reisman

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