ETC providers tackle 'contango' issues

There are two main types of ETCs, physical and synthetic. Physical ETCs, just like physical ETFs, buy and hold the asset they track. However these only track precious metals such as gold and industrial metals such as aluminium and copper. This is because, while it is possible to buy and store metals, it is not so easy to store oil & gas, for example, because of the sheer volumes involved and it is not practical to store perishable agricultural commodities. So most commodity ETCs get exposure by tracking futures contracts based on commodities.

This means they do not track the spot price of a commodity but the prices of the futures. These contracts represent an agreement to exchange a standardised quantity and quality of a particular commodity at a price agreed today but for a future delivery date. When the futures are about to expire they have to be sold and new futures purchased. If the cost of the new futures is less than those being sold this is beneficial to investors in the ETC, and mean profits can be higher than that suggested by the the spot price. This is known as 'backwardation'.

However, if the cost of the new futures is more than what you get for selling the contracts you make a loss, known as 'contango', possibly leading to underperformance of the spot price.

As a result, a number of index providers have launched indices to try to reduce the effects of contango and enhance the return to investors. And ETF providers, including db X-trackers and iShares, have launched funds that track these.

Indices such as the S&P GSCI Dynamic Roll series consider a broad range of futures when it is time to buy a new one - rather than just buying a similar one to that which they just sold - if it is in contango. These indices try to choose the contract that offers least contango or most backwardation, alongside considerations such as ability to buy and sell, and costs.

db X-trackers' funds include db Energy Booster ETC (XCT8), which aims to track the performance the performance of the S&P GSCI Energy Index. This strategy seeks to minimise the costs in contango markets or maximise the benefits of replacing contracts approaching expiry with longer-dated contracts based on the shape of the relevant commodity forward curve.

However, tracking these indices does not guarantee that you will not make a loss. For example, if oil one-month futures are in contango the ETC may buy a 12-month futures contract. But if an unexpected event such as a crisis in the Middle East caused the one-month futures contract price to move up sharply you would still lose out.

"These strategies are all right as long as the assumption on where they will trade remains, but if it is wrong you could lose a lot of money," says Gordon Rose, fund analyst at Morningstar. "Futures with longer maturities have less drawdown but offer less potential added value."

Edward Allen, portfolio manager at Thurleigh Investment Managers, adds that longer-dated futures are potentially more volatile.

Nicholas Brooks, head of research and investment strategy at ETF Securities, says a better way is to slightly increase the average maturity of the contracts the ETC tracks because you renew these less often, reducing the effect of contango. ETF Securities offers a number of funds that track longer-dated futures with maturities of around four to six months, such as ETFX DJ-UBS All Commodities 3m Forward ETC (CMFP). "Over the past 10 years longer-dated futures have often outperformed classic ones," he says. "This has particularly been the case with natural gas and agricultural commodities, which have experienced contango drag. However, this does not necessarily mean investors made a bad return but rather they have reduced the theoretical return they could have made. But, over the past 10 years, investors in oil futures have largely benefited from backwardation and have got a better price than if they invested in the spot price."

He also points out that the more complicated an index is the more costly it is to replicate, eating into performance.

With much longer-dated futures, liquidity - how easy it is to buy and sell - is not as good. "This is why we prefer to use ones with four- to six-month maturities, because it lowers transaction costs and you get better liquidity," says Mr Brooks.

ETCs that use futures are swap-based, which means that, rather than the ETC buying and trading futures, a counterparty, usually an investment bank or insurance company, does this on their behalf in exchange for the returns from a basket of collateral the ETC holds. This also introduces the risk of a swap counterparty failing to deliver the return. However, providers such as iShares mitigate this by using multiple swap counterparties and overcollateralising by up to 20 per cent with high-quality and liquid equities and bonds. db X-trackers fully collateralises its ETCs using assets such as gold, while the DBCLI-OY Balanced UCITS ETF holds collateral worth at least 90 per cent of its assets.

If you do decide to make use of ETCs that aim to mitigate contango Mr Rose says that it is important that you understand what the product's strategy is and how it works. And some wealth managers, such as Christopher Aldous, chief executive of Evercore Pan Asset, believe these products are better for traders than investors.

If you have a medium to long-term investment horizon, in the case of metals where there are physical funds available, these could be a better option.

ETCs with futures-enhanced strategies

Source: Morningstar