By Michael Johnston of ETF DatabaseThe surge in popularity of exchange-traded funds is often credited with bringing buy-and-hold investors a cost-efficient alternative to traditional actively managed mutual funds. But ETFs are also responsible for bringing several asset classes previously available only to the largest and most sophisticated individuals and institutions within reach of investors on all levels. While this "democratization" of investing is generally a positive development, it does come with some potential pitfalls. The specifics of the exposure to some of these hard-to-access asset classes is available to investors willing to do the research, but it isn't always quite what those who only do cursory research may imagine. >>Want More ETFs? Visit Our ETF Screener Page
Contango: A Bad Word for ETF InvestorsIn many cases, ownership of the underlying asset to which ETFs offer exposure is either impossible (e.g., equity market volatility) or impractical/prohibitively expensive (e.g., crude oil or live cattle). So in many cases, the best way to gain exposure to a particular asset is through a futures-based strategy. Many exchange-traded products buy "near month" futures contracts, and to avoid ever taking physical possession of the underlying, they sell the current month contract before it expires and buy into the next month's process. This process, referred to as "rolling forward," can result in the ETF either forking out more cash if the price for second-month contracts is higher than the current month (contango) or taking in cash if the opposite is true (backwardation). See this article for a more in-depth look at how this process works. So when the slope of the futures curve is steep and upward-sloping, investors essentially put themselves in a hole from the beginning, needing a rise in prices just to break even. It should be noted that a number of factors can cause a market to go into contango, including market expectations for rising prices. Three primary factors affect the prices of ETFs that utilize a futures-based strategy: 1) changes in the spot price, 2) interest income on cash, and 3) the "roll yield." Below, we highlight three ETFs or ETNs that could face some strong headwinds from the third of these factors in coming months.
iPath S&P 500 VIX Short-Term Futures ETN ( VXX)
iPath Dow Jones-UBS Grains Subindex Total Return ETN ( JJG)