Commodity ETF Ideas: Profiting From Backwardation

by on February 16, 2011 | ETFs Mentioned:

By now, most investors are well aware of certain nuances of futures-based investment strategies that are capable of having a significant impact on the returns of exchange-traded commodity products. A select few of the 70+ commodity ETPs on the market offer exposure to natural resources by physically buying and holding the commodity; these “physically-backed” commodity ETFs generally focus on assets with high value-to-weight ratios–such as precious metals. But for the vast majority of commodities, exposure through a physically-backed structure simply isn’t possible–there are obvious hurdles to funds that invest in live cattle or barrels of crude oil.

Most commodity ETFs implement futures-based strategies, offering exposure to everything from corn to gold to tin by investing in contracts that generally exhibit very high correlations to movements in spot prices. Since the commodity ETF boom began a few years ago, many investors have learned about the potential pitfalls of futures-based strategies–including the adverse impact of contango on exchange-traded products.

While commodity ETFs often  move in the same direction as the underlying resource over the short-term, upward-sloping futures curves can cause significant “return lags” between these funds and a hypothetical return on spot prices. More than a few investors have expressed frustration with the return erosion resulting form contango, and the phenomenon has likely had an impact on the considerable cooling of interest in commodity ETPs over the last year [see Commodity ETFs Get No Love From Investors].

While contango has been a thorn in the side of investors seeking commodity exposure, there is another more appealing side of the futures-based coin. When futures markets are backwardated–meaning that longer-dated contracts are cheaper than those approaching expiration–investors have the wind at their backs. Futures-based funds are more likely to be able to sell high and buy low, potentially allowing these strategies to perform better than a hypothetical spot investment [see Under The Hood Of The "Contango Killer" Commodity ETF].

Backwardation is the exception rather than the rule in the world of commodity futures, but it isn’t completely unheard of. Currently, there are a handful of commodity ETNs that offer investors a chance to exploit a downward-sloping futures curve, potentially profiting even if the value of the underlying commodities decline:

iPath Lead ETN (LD)

Perhaps one of the most obscure commodity ETPs, LD offers exposure to an industrial metal that has recently soared to new highs thanks to strong demand from emerging markets. Though some expect the rally to continue, it appears that investors generally expect lead prices to weaken going forward; the market for LME lead futures is sloping downward. Recent prices for a 27-month seller reflected a discount of about 4% to cash settlement–not a huge difference, but a bit of padding for investors interested in this commodity [see Are Physically-Backed Metal ETFs A Good Idea?].

iPath Sugar ETN (SGG)

Sugar prices also surged to new heights in 2011, making an investment in SGG appealing even to investors who think that the rally may not have much room left to run. The market for sugar futures reflects sentiment among investors that a downward correction in prices is coming; March 2012 contracts are trading at a discount of more than 20% to futures expiring in March of this year. That translates into an opportunity to profit if prices remain stable, and gives some pretty nice padding even if a slide in sugar prices does materialize [see SGG Tumbles: Historic Day For The Sugar ETF].

iPath Cotton ETN (BAL)

Cotton may seem more like a choice of clothing than an investment opportunity, but this commodity was one of the best performing assets of 2010. After nearly doubling in price over the last year, cotton–or rather the cotton ETN–is attractive thanks to a steep, downward grade in the futures market. May 2012 contracts are about 40% cheaper than the next-to-expire March 2011 contracts, and the drop-offs continue from there. An investment in bales of cotton might not be a great idea, but it’s difficult to imagine a scenario that results in a futures-based approach to cotton performing poorly–there’s a pretty strong wind at the backs of investors in BAL [see Six ETFs That Surged To Start The Year].

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Disclosure: No positions at time of writing.