Contango: 1 Key Reason Not to Buy These ETFs – United States Natural Gas Fund, LP (UNG)

Looking at current natural gas futures, the April contract currently trades at a price that’s nearly $0.05 below the May contract. That may not seem like much, but it represents almost 1.5% of the contract’s price at the moment. When the ETF rolls its futures contracts forward to the next month, the price is tied to that higher amount.

If the futures price accurately reflects what the spot price will be in May, then spot gas investors will enjoy a $0.05 gain in value for their natural gas holdings. But the ETF will miss out on those gains, losing 1.5 percentage points of return. Conditions aren’t that bad every month, and sometimes nat-gas has been in backwardation. But over the years, contango has ravaged the ETF’s relative returns.

How volatility works against you
You can see the same phenomenon in the volatility-tracking iPath S&P 500 VIX Short Term Futures TM ETN (NYSEARCA: VXX) and the related leveraged VelocityShares Daily 2x VIX Short Term ETN (NYSEARCA: TVIX). Currently, the March VIX futures contract trades at a level of 16.39, but the corresponding April contract is at 16.91, more than 3% higher. As a result, ETFs that use a monthly roll-forward strategy currently face headwinds of 3 percentage points per month against their return.

But for inverse ETFs, contango can actually help. The VelocityShares Daily Inverse VIX ST ETN has soared over the past year, largely due to low volatility. But because of its inverse orientation, contango has worked to the ETN’s benefit, providing a boost to monthly returns.

The article Contango: 1 Key Reason Not to Buy These ETFs originally appeared on Fool.com and is written by Dan Caplinger.

Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned.

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