Commodity ETFs: The Sad Saga of Contango

ETF investor should use much caution before investing in commodities, especially in funds that use futures and other derivatives. The explanation for lies in something called contango. That’s a word that nearly all investors in commodity ETFs, at least those that rely on futures contracts, wish to heck they never heard.

Contango refers to a situation where distant futures prices for a particular commodity start to run well ahead of near futures prices.

In other words, if you want to maintain a futures position that looks one month out, you buy futures contracts for the next month that expire in 30 days. Then one month later you replace them with contracts that contango has made more expensive. The effect is sort of like holding a fistful of sand and watching the sand sift through your fingers until you are left with nothing but an empty hand.

The actual price of natural gas, for example, dropped precipitously in the past several years because new gas drilling technologies and the discovery of new reserves have increased supply beyond demand. But buyers of Victoria Bay’s United States Natural Gas Fund (UNG) were not tapping into these falling prices each month.

Instead, they were buying future contracts each month that were more expensive than the futures contracts they replaced. Why? The explanation is complicated, but the buying pressure coming from investors themselves helped to fuel the inflated futures’ prices. On top of that, speculators, knowing that funds such as UNG had to buy additional futures contracts as the old ones expired, started to front-run the purchases and drove prices higher yet.

As a result of contango, many commodity investors have lost money, and some have lost lots of money, in recent years — even in cases where, as with oil, the price of the commodity itself rose. The illustrious managers at Victoria Bay led their investors to slaughter. But more experienced managers were also caught with their trousers down.

As if that weren’t bad enough, any gains on the sale of funds that use futures are taxed largely at short-term capital gains rates, even if the funds were held for more than a year — just another one of those IRS quirks. (Granted, not many people have had this problem recently because gains are hard to come by with these funds.)

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Source:http://www.dummies.com/how-to/content/commodity-etfs-the-sad-saga-of-contango.html