How Contango Affects Your Investments

Funds that invest in futures may experience contango, which can mean losses for the funds.

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Investing in commodities was once a privilege reserved only for institutional investors, but today individuals can access this complex slice of the market through an increasing number of exchange-traded funds and mutual funds that employ sophisticated strategies. Of the 106 commodities mutual funds on the market, 30 percent have launched since 2008, and more than half of the 167 commodity ETFs have launched since that time, according to Morningstar. But before jumping into this sector, experts say it's important for investors to understand some of the peculiarities in the commodities market. One of the most problematic is a phenomenon called contango.

[See 4 of the Biggest Risks Investors Are Facing.]

There are three ways investors can access commodities: through stocks of commodity-producing companies, funds that track the spot price of the commodity such as gold or silver, or derivatives such as futures contracts. The latter is the most complicated strategy, as funds that invest in futures can experience contango. This state occurs when a commodity's futures price is higher than its current spot price. In this scenario, even if the spot price of a commodity is rising, it's possible to lose money in a fund that tracks the futures price of the commodity.

Contango is linked with supply and demand. "A contango market is more likely to happen when inventories of the commodity are high because, basically, the opportunity cost of storing that commodity goes up when people don't need it right now," says Kathryn Young, mutual fund analyst at Morningstar. "If inventories are very low, people are willing to pay a premium to get the commodity now."

Some funds, by design, require the manager to buy a new futures contract at the end of each month. "An ETF that holds futures contracts is going to have worse returns than the physical commodity if the market remains in contango, because the fund manager has to go in and buy a more expensive futures contract," says Tom Lydon, editor of Depending on the market and the fund, this phenomenon can continue for months at a time.

Diversification is one of the best ways to avoid contango, says Young. She suggests investing in a broad-based fund that holds a variety of commodities since not all commodity markets experience contango at once.

Oil ETFs, in particular, have experienced contango in recent years. One such ETF is United States Oil (USO). Christian Magoon, CEO of asset management consultant firm Magoon Capital, says most investors would be better off buying an ETF that tracks a number of oil production and services companies. An example is SPDR S&P Oil & Gas Exploration & Production (symbol XOP), which includes ConocoPhillips, ExxonMobil, and Occidental Petroleum among its holdings. By investing in such stocks, he says, you'll gain indirect exposure to the price of oil without the difficulties of trying to directly track the price of it.

[See How to Invest in Rising Oil Prices.]

Other diversified ETFs Magoon recommends include PowerShares DB Commodity Index Tracking (DBC), which follows the Deutsche Bank Liquid Commodity Index that tracks a basket of 14 commodities. For mutual fund investors, Young favors Harbor Commodity Real Return (HACMX), which is subadvised by PIMCO and managed by Mihir Worah, who also runs PIMCO Commodity Real Return (PCRAX). Worah invests in derivatives that seek to replicate the performance of the Dow Jones-UBS Commodity Index, which represents 19 different commodities.

Twitter: @benbaden

Corrected 2/24/2011: A previous version of this story incorrectly identified Magoon Capital. It is a asset management consultant firm.