Dealing with Contango

Investing in commodities has been made much easier by the advent of exchange traded funds.  However, one issue that has been a drag on returns and has investors scratching their heads is contango.

Contango, and its opposite number — backwardation, occurs in funds that track commodity prices with futures contracts.  Since the contracts have a limited life, the fund has to periodically roll over its position into new contracts.  When the new contracts are pricier than the existing contracts, contango for short, investors give up some gains to retain their exposure.

In the article Getting Tripped Up by Contango, Carolyn Ciu points to the U.S. Oil Fund (USO) as a prime example of a fund that has been hurt by the rollover problem.  USO has fallen 44% since the fund’s 2006 launch while spot prices have risen 28% over the same period.

To dilute the contango effect, some funds spread their exposure across multiple contracts or are more selective about which contracts to buy.  For example, the PowerShares DB Oil Fund (DBO) chooses the cheapest forward contract to roll into.

To avoid contango altogether, some commodity funds simply purchase and store the physical assets.  For example the SPDR Gold Shares (GLD) stores $57 billion of gold in vaults in London.  The fund’s manager even maintains and publishes a list of the gold bars that the fund owns and holds.

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