Be Aware of Contango in Commodity ETFs

One inherent characteristic of many commodity-based ETFs and ETNs is contango.
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NEW YORK (TheStreet) -- The debt crisis looming in Europe and a growth slowdown in China has driven commodity prices to their biggest slump since the demise of Lehman Brothers, enabling some to believe that a rally in the alternative asset class may be in the near future. Whether or not a rally in commodities will take place, it is important to be aware of their inherent risks.

As the appeal of exchange-traded funds has magnified, so has that of commodity-based ETFs and exchange-traded notes. One inherent characteristic of many commodity-based ETFs and ETNs is contango. Contango arises when the front-month futures contracts are cheaper than second-month futures contracts. To simplify, it is when the price of a commodity for future delivery is higher than the spot price (the opposite phenomenon occurs as well, and this is known as backwardation).

This affects ETFs and ETNs that are futures based or are tracking commodity indices such as the S&P GSCI and the DJ-AIG indexes, which typically invest their cash in just the front-month futures contracts of the commodities they are tracking. The way these ETFs are affected is that contango generates what is known as a negative roll yield. This negative roll yield could potentially eat away at the returns of the ETF and cause tracking errors. Additionally, the wider the spread, or "contango effect," the higher the potential that the negative roll yield will eat away at the net asset value of the ETF. When markets are in contango, which some argue is a normal price relationship which reflects the costs of carrying the commodity, the relative ETF will underperform its underlying commodity.

Some commonly traded ETFs that have been influenced by contango include the

US Oil Fund

(USO) - Get Report

, the

United States Natural Gas Fund

(UNG) - Get Report

and the

iPath S&P GSCI Crude Oil Total Return Index ETN

(OIL) - Get Report

. As for USO and UNG, their investment goals are to follow the percentage change in the price of their respective commodities front-month contract and therefore don't always mimic the performance of their respective underlying index.

If investing in these commodity-based exchange-traded products, utilizing an exit strategy which identifies specific price points at which they could continue to decline in value could help mitigate the risks.

According to the latest data at

SmartStops.net

, these price points as of Friday's market close are USO at $31.34, UNG at $7.43 and OIL at $20.30.

Written by Kevin Grewal in Laguna Niguel, Calif.

At the time of publication, Grewal had no positions in the securities mentioned.

Kevin Grewal serves as the editorial director and research analyst at The ETF Institute, which is the only independent organization providing financial professionals with certification, education, and training pertaining to exchange-traded funds (ETFs). Additionally, he serves as the editorial director at SmartStops.net where he focuses on mitigating risks and implementing exit strategies to preserve equity. Prior to this, Grewal was an analyst at a small hedge fund where he constructed portfolios dealing with stock lending, exchange-traded funds, arbitrage mechanisms and alternative investments. He is an expert at dealing with ETFs and holds a bachelor's degree from the University of California along with a MBA from the California State University, Fullerton.