Commodities Exchange-Traded Funds: Drivers of Futures Contracts

The futures contract has three drivers:

1. The first is the spot return, the change in the price of the target commodity. Under most circumstances, the change in price of the underlying commodity is the primary driver of the futures return. However, the futures can deviate from the spot return significantly.
2. The second driver of returns is called the collateral (or cash) return. Commodity futures-based ETFs margin their positions with cash and cash equivalents, which are held as interest-earning collateral.
3. The third driver of return for commodity futures based ETFs is created by the purchase and sale of constituent futures contracts. To avoid physical delivery of a target commodity, and to maintain futures market exposure, funds will "roll" their contracts forward as they approach expiration. This entails selling the contract approaching expiry and purchasing a contract that expires further in the future. Commodity futures contract prices can vary from the spot price, which immediately creates an "implied roll yield." If the contract price is less than the spot price, an investor would experience a positive roll yield. The opposite would be true if the contract price were greater than the spot.

Backwardation and contango explained

Markets whose futures contracts become cheaper at later expiration dates stand to garner positive roll yields and are said to be in a state of "backwardation." Markets whose futures contracts become more expensive at later expiration dates stand to garner negative roll yields and are said to be in a state of "contango." As commodity futures based ETFs roll their futures positions forward, they stand to take a loss. Therefore, persistent contango can have a significant adverse impact on the returns of a long futures strategy.

Originally, futures contract-based ETFs rolled at predetermined intervals (usually one month out). This left funds more vulnerable to the effects of backwardation and contango, but new funds attempt to mitigate such effects by purchasing contracts of a number of different expirations, across various sectors; in some cases they may even take short positions.

Issues with single-commodity futures-based ETFs

Single-commodity futures-based ETFs have also come under regulatory scrutiny for several reasons. In some cases, funds can run up against their position limits. In this case the fund may be forced to cease share issuance and may trade at a premium. Some funds have been forced to turn to swaps to satiate excess market demand once position limits have become an issue. The large amount of demand that they inject into the commodity futures space on the long-side has been identified as a possible driver for consistent contango. Investors should stay aware of regulatory reform going forward though funds holding a broadly diversified basket of commodity futures should be considered the least likely to be affected.