Investors run into new concepts all the time, and to be successful with your investments, you have to understand all the factors that can affect your portfolio and its holdings. Those who invest primarily in stocks typically know the ins and outs of the businesses in which they own shares along with the risks they face. Investing in futures contracts — or in the exchange-traded funds that themselves have holdings in futures contracts — can expose you to some risks that you’ve never heard of before.
One of those potential risks is called contango, and it has to do with the relationships between different futures contracts on the same product. Many ETFs have fallen prey to the negative long-term impact of contango, but unless you know what it is, you won’t necessarily recognize whether an ETF is using an investment strategy that puts you at risk.
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What is contango?
The terms contango and backwardation both refer to current conditions in a futures market for a given commodity. A futures market is said to be in contango if the price of a futures contract that expires sooner is less than the price for a later-expiring futures contract. If the price of the later contract is less than the one that expires sooner, then the market is said to be in backwardation.
To understand why contango matters, it’s important to know how futures trading typically works. For most commodities, there are a relatively small number of futures market participants who are actually interested in buying or selling the underlying commodity good. For instance, oil producers might sell crude oil futures contracts to lock in prices for their production, while oil refiners might buy futures contracts in order to lock in what they’ll have to pay for raw crude oil to make gasoline, diesel fuel, and other refined products. Similarly, farming operations might sell crop futures to processed food manufacturers that need those crops as ingredients for their prepared food items. In these cases, these parties will hold onto their futures contracts until expiration and then make good on whatever delivery responsibilities are called for under the contracts.
Most futures investors are speculators who don’t want to have to deal with how to handle thousands of barrels of oil or thousands of bushels of corn. For them, the natural thing to do is to close out their futures positions right before the contracts expire. These speculators can either find other speculators on the opposite side of the trade with offsetting positions, or they can find investors like the ones above who actually want to hold the futures contract to expiration. After they do so, many speculators simply turn around and open a similar position on a futures contract at some point in the future.
That wouldn’t pose a problem if the prices for futures contracts in different months were the same. But most of the time, the price differs. In particular, for a market that’s in contango, the price of the replacement futures contract will be higher than the price of the contract that just expired. That creates a small amount of friction that over time can add up to a huge downward pull on the return for a given futures investment compared to the spot price of the underlying product.
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Where you’ll find contango
Contango has had the biggest impact on ETFs that invest in futures contracts. Products like United States Natural Gas (NYSEMKT: UNG) and United States Oil (NYSEMKT: USO) have lost most of their value over the past decade, and only part of their declines have come from weak energy prices. Prevailing contango gradually eroded the ETFs’ assets by forcing the funds to pay incrementally more to roll forward expiring futures contracts month after month.
Yet you can’t count on any given market always being in contango. For instance, crude oil futures have generally traded at higher prices than spot crude, but over the past several months, strong demand has pushed spot prices higher and caused the market to go into backwardation.
Some commodities go through seasonal fluctuations that have them sometimes in contango and other times in backwardation. For instance, natural gas demand is highest in the winter due to demand for heating, so futures contract prices tend to rise the later you go into the late fall and winter months. By spring, prices fall off as warm weather returns, so futures contracts reflect that demand drop with lower prices than in the preceding winter months.
One area that was in contango for a long time was the volatility futures market. For years, those betting against rising volatility could invest in futures and make small but steady incremental gains. The risk was that a sudden jump in volatility would create losses that would wipe out all of those small gains, and many investors found that out the hard way earlier this year during a brief volatility spike when shares of inverse volatility ETFs like ProShares Short VIX ST Futures (NYSEMKT: SVXY) suffered catastrophic declines.
Know the risks
Futures contracts are very useful in some cases, but they have risks that most stock investors don’t know about. By being aware of contango and backwardation, you can identify potential long-term threats to your portfolio that others will miss, avoiding nasty and costly mistakes.
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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool owns shares of ProShares Short VIX Short-Term Futures ETF. The Motley Fool has a disclosure policy.
