“Investors tend to suffer when the near-future commodity futures their fund needs to sell are priced below the expensive, longer-dated ones it needs to buy — a pricing discrepancy that’s the essence of contango.” – Barron’s writer Brendan Conway
The new iShares Dow Jones-UBS Roll Select Commodity Index (NYSE:CMDT) is the answer to the prevalent contango contagion. Composed of a diverse makeup that ranges from energy commodities to soybeans, the index seeks to minimize negative effects on fund performance realized by the act of “rolling” forward contracts.
For those unfamiliar with the specifics of futures trading, contango occurs when the forward price is greater than the spot price. Conversely, backwardation occurs when the spot price is greater than the forward price.
The effects of this imbalance can be seen on the following price curve. Note contango’s forward curve, its backwardation inverse and their combined divergence from the expectation hypothesis:
In a real scenario, as a futures contract’s expiration date approaches, a trader looking to avoid holding the bag through delivery will “roll” into the later contract. The trader thereby extends the time horizon on his position. Unfortunately, during this process, the effects of contango act as a definite trading head-wind.
That’s where $CMDT comes in.
$CMDT will combat price-imbalance by rolling into futures contracts that display more backwardation – or less contango. In this way, the ETF seeks to make commodity trading/investing a more streamlined, efficient process.
And timing of the ETF’s release couldn’t be better…
In recent years, the sheer amount of time commodity markets existed in this state of price-imbalance was remarkable. According to S&P Dow Jones Indices commodity strategist Jodie Gunzberg, from 2005 to 2011, commodity markets remained in a state of contango 93% of the time.
Speculation points to prevalence of backwardation in the wake of world growth increasingly driven by expansion of demand. But history shows that contango has been more common, and will likely remain a hindrance into the future.
So, if you see futures trading on the horizon, perhaps you ought to give $CMDT a roll.
Categories: Equity Markets