Special Feature: Commodity ETFs – Facts and Fiction about Spot and Futures Prices
Knowing whether an ETF tracks spot or futures prices will help you better understand its performance. Futures-based ETFs, the most common structure for commodity ETFs, are subject to contango and backwardation. Read what this will mean for ETF investors.
BY MICHAEL LACINI | CHARLES SCHWAB INVESTMENT ADVISORY | SAN FRANCISCO (CA)
One feature many investors like about exchange-traded funds (ETFs) is the ability to access parts of the market that were previously very hard to reach. An example is the commodities asset class—hard to access in the past, but easier now with ETFs. Commodities have their own risks and aren’t for everyone, but may be appropriate for investors looking for the opportunity to diversify beyond stocks and bonds. Commodity ETFs work a bit differently from traditional stock and bond ETFs, though, and it’s important to understand the difference before diving in. In order to understand how a commodity ETF works, you’ll need to know whether it tracks spot prices or futures prices.
Spot prices and futures prices
The spot price of a commodity is the price that it is trading at right now. If you wanted to buy a barrel of oil or a bushel of corn to take home today, you would pay the spot price. This is the price that you will often see quoted in the news. The futures price is the price you would pay today for the right to receive the commodity at some point in the future (say, three months from today). With a futures contract, you’re locking in a price today rather than waiting to see what the spot price will be at some point in the future and then making the purchase at that price.
Physical ETFs vs. futures-based ETFs
Some ETFs hold the physical commodity itself. This is most common with precious metals such as gold and silver, because storing the commodity is fairly straightforward: Buy bullion and put it in a vault. If your ETF holds the physical commodity, the value of your ETF shares will move with the spot price of the commodity, though the price could also be affected by security issues around storing the physical commodity itself. Other ETFs hold baskets of futures contracts and never take possession of the physical commodity. This is the most common commodity ETF structure, whether it’s for oil, agricultural commodities, broad baskets of commodities or even some precious metal ETFs. Storing oil or wheat is more difficult than storing bullion, which is why these ETFs don’t just hold the physical goods. If an ETF holds futures contracts, it will have to roll those contracts whenever they get close to expiration. This means that as the maturity date of the futures contract gets close (that is, the contract the ETF bought three months ago is getting close to the date on which the commodity is to be delivered), the ETF manager will sell the contract that is ready to expire and buy new contracts for a future date. The impact on the ETF’s returns from this continuous process of selling expiring contracts and buying longer-dated contracts is called roll yield.
Contango and backwardation
Sometimes, roll yield can be positive. Imagine a market where the people who are buying and selling futures contracts expect the future price of the commodity to be lower than it is today. Maybe the spot price is $50, but the futures price in three months is only $48. If you buy contracts for $48 but the price remains at $50, you’ll be able to sell those contracts for close to $50 when they’re getting close to maturity, and replace them with longer-dated contracts for $48. The roll yield would be positive because you’re constantly buying at a lower price and selling at a higher price. A market in which the futures price is lower than the spot price is said to be in backwardation. Historically, many commodities have tended to trade this way, and for those commodities, this is known as normal backwardation.
How does contango affect your ETF?
An ETF that holds futures contracts is going to have worse returns than the physical commodity if the market remains in contango (and better returns if the market is in backwardation). Every time the ETF manager rolls the futures contracts (selling the expiring contracts and buying longer-dated contracts), the ETF is losing money. The steeper the contango, the worse the relative return on the rolling futures contracts compared to the spot price of the commodity. In a nutshell, the risk with a futures-based ETF is that contango could erode returns.
What to do?
So what can you do about this? First, always keep in mind that the process works in investors’ favor if the market for a commodity is in backwardation. However, if the market is in contango (as has been the case with oil recently), there are a few things to consider:
- ETFs that hold a physical commodity are not subject to contango (though such ETFs aren’t available for every commodity).
- An ETF that spreads its assets among shorter- and longer-dated futures contracts will roll less of its portfolio each month, therefore lessening the impact of contango.
- Certain ETFs are constructed specifically to avoid the negative impact of contango (or to take advantage of the positive impact of backwardation) by tracking indexes that select futures contracts with the most favorable roll yield.
Investing in products that use commodity futures contracts requires a basic understanding of contango and backwardation. With some careful research, you can choose products that suit your investing strategy and your views on the direction of the market.◄