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Funds to Minimize Impact of Contango

NEW YORK ( TheStreet) -- Oil prices are soaring, but investors in United States Oil Fund (USO), have little cause to cheer. The ETF, which aims to track the price of a barrel of oil, has only recorded small gains. During the past year, the fund returned 3.8%, while the price of oil climbed more than 20%.

Part of the problem can be traced to a condition in futures markets that traders call contango. For the past several years, the problem has pulled down results of many ETFs. Now companies have introduced a number of mutual funds and ETFs that are designed to reduce the impact of contango. Funds that have opened recently include United States Commodity Index Fund (USCI), United States 12 Month Oil Fund (USL), and Van Eck CM Commodity Index Fund(CMCAX).

Contango plagues some ETFs because of the way they are structured. Instead of holding actual oil or other commodities, the ETFs trade futures. Each month the portfolio managers buy futures contracts that that represent bets on the price of oil in 30 days. Near the end of the month, the managers sell the contracts and buy new one-month futures.

Say the price of the old one-month future is 100, and the cost of the next 30-day contract is 101. The portfolio manager must sell the old contract and then invest in a new contract with a higher price. That can result in a loss, and the market is said to be in contango.

Contango can be a particular problem during periods when commodity prices are rising, and investors think prices will be higher in the future. "Contango has been ongoing in recent years, but we are seeing particularly severe conditions in the oil markets now," says Kristen Capuano, marketing director of Van Eck Funds.

To boost returns, Van Eck CM Commodity Index Fund (CMCAX) tracks a benchmark that was designed to minimize contango, the UBS Bloomberg Constant Maturity Commodity Total Return Index. Besides tracking one-month contracts, the index also includes contracts with maturities of 6 months, 1 year, and 3 years.

The diversification helps to limit the effects of contango because the prices of the different contracts vary. Right now 3-year crude contracts on the New York Mercantile Exchange are about 101, cheaper than the 1-month contract, which is priced around 102.The benchmark sells some of its contracts every day and rolls into new ones. Because some of the trades are likely to be profitable, the new index could outperform old-style benchmarks during periods when contango plagues one-month contracts.
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