According to Barclays Capital, commodities exchange traded funds (ETF) and other securities linked to raw materials had jumped 50-fold in a decade from $5.5 billion to $277 billion as of 2009! Yet some were losing big due to ‘contango trap’!
Contango is a word traders use to describe a specific market condition, when contracts for future delivery of a commodity are more expensive than near-term contracts for the same stuff. It is common in commodity markets. When the futures contracts that commodity funds own are about to expire, fund managers have to sell them and buy new ones; otherwise they would have to take delivery of billions of dollars’ worth of raw materials. When they buy the more expensive contracts—more expensive thanks to contango—they lose money for their investors. Contango eats a fund’s seed corn, chewing away its value.
The Standard & Poor’s Goldman Sachs Commodity Index (S&P GSCI), which tracks 24 raw materials, is the basis for as much as $80 billion of investment. Managers of funds linked to the index, created by Goldman in 1991, have to buy their next-month futures contracts between the fifth and the ninth business day of each month. During that period in May 2010, fund managers sold contracts for June delivery of crude oil priced at $75.67 a barrel, on average, according to data compiled by Bloomberg. Managers replacing those futures with July contracts had to pay $79.68. After the roll period ended, the July contract fell back to $75.43. For each of the thousands of contracts, in other words, managers paid $4 for nothing—and the value of their funds dropped accordingly.
Contango isn’t the only reason commodity ETFs make lousy buy-and-hold investments. Professional futures traders exploit the ETFs’ monthly rolls to make easy profits at the little guy’s expense. Unlike ETF managers, the professionals don’t trade at set times. They 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. The strategy is called “pre-rolling.”
A look at 10 well-known funds based on commodity futures found that, since inception, all 10 have trailed the performance of their underlying raw materials, according to Bloomberg data. The biggest oil ETF, the U.S. Oil Fund, which Wolf bought and which now has $1.9 billion invested in it, has dropped 50 percent since it started in April 2006—even as crude oil climbed 11 percent. The $2.7 billion U.S. Natural Gas Fund (UNG), offered by the same company, has plummeted 85 percent since its launch in April 2007—more than double the 40 percent decline in natural gas. Deutsche Bank’s (DB) PowerShares DB Agriculture Fund (DBA) has eked out a 3 percent total return since January 2007, while the weighted average of its commodity components has risen 19 percent. To be sure, those spot prices—reported on cable business channels and other outlets—set an unreachable benchmark. If investors try to match the spot market using ETFs, they can get killed by contango. If they dodge contango by buying physical commodities instead, they must pay heavy storage costs that can easily turn gains to losses.
Reference: Business Week, 20100722, “Amber Waves of Pain”