Three Commodity ETFs In “Anti-Contango”

by on March 22, 2010 | ETFs Mentioned:

Exchange-traded commodity products have been embraced by investors eager to add an asset class to their portfolio that has historically exhibited a low correlation to stocks and bonds. Commodity ETPs saw more than $30 billion in cash inflows last year as both funds targeting diversified baskets of resources and commodity-specific funds surged in popularity.

As the use of exchange-traded commodity products has become more common, investors have become more educated on the nuances of various strategies. While some commodity products physically buy and hold the underlying resources, the majority utilize a futures-based strategy to achieve exposure (see What Every Investor Should Know About Commodity ETF Investing). While futures-based funds exhibit a strong correlation with spot prices of the related commodities, there are other factors that can have a potentially significant impact on overall returns.

When futures markets are in contango (i.e., near-dated futures are cheaper than longer-dated contracts), the process of rolling contracts approaching expiration can eat into investor returns. If an exchange-traded product rolls its holdings frequently enough, the “roll yield” can account for a significant portion of the total return, and has the potential to create a drag on an investment. This scenario isn’t just hypothetical; in 2009, UNG lost more than 55% of its value, despite the fact that spot natural gas prices finished the year about where they began.

The nuances of futures-based investment strategies have frustrated some investors who have come to the conclusion that a return drag is inevitable. But a futures-based strategy doesn’t always work against investors. When futures markets are in backwardation, near-dated contracts are more expensive than long-dated contracts. This creates the potential to for investors to pick up excess return in the roll process (although any gain can obviously be negated by the anticipated decline in prices).

Earlier this month, we took a look at commodity ETFs facing steep futures curves (see Three ETFs That Could Be Crushed By Contango). Below, we profile three commodity products that could potentially generate a positive roll yield in coming months, selling relatively expensive futures to buy less expensive contracts.

3. United States Gasoline Fund (UGA)

This fund is designed to track the movements of gasoline prices. To accomplish this objective, UGA is currently invested primarily in May RB gasoline futures traded on the NYMEX (see the fund’s holdings here). Although some analysts are expecting gas prices to surge as the summer driving season approaches, the futures curve slopes downward until the end of 2010.

UGA

2. iPath Dow Jones-UBS Sugar Total Return ETN (SGG)

SGG is one of the most volatile exchange-traded commodity products available to U.S. investors, often moving by at least 200 basis points in a single session. This fund has taken investors on a wild ride over the last several months, surging between December of 2009 and the end of January before entering into a freefall that saw 35% of value erased over six weeks.

From the looks of the futures curve for NYMEX-listed sugar futures contracts, investors think sugar still has a ways to fall before bottoming out; October contracts are trading at a 5% discount to May futures.

SGG

1. iPath Dow Jones-UBS Livestock Total Return ETN (COW)

Many investors have considered the addition of livestock as a hedge against an uptick in inflation in coming months, as food prices are often among the first to climb during periods of rising prices. This cleverly-named ETN is linked to an index consisting of futures contracts on two livestock commodities, including lean hogs and live cattle. While the market for hog futures is in contango, the exact opposite is true for live cattle. August futures contracts were recently trading for about 5% less than April contracts, a significant discount considering the storage costs associated with this commodity.

COW

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Disclosure: No positions at time of writing.