The growth and adoption of exchange traded funds (ETFs) by retail investors has allowed them to access a wide range of asset classes and strategies once reserved for wealthy and institutional investors. While assets like convertible bonds, floating rate bank loans and others are now common place in portfolios, the boom in ETFs has really brought commodity investing to the masses.

There are now dozens of natural resource focused funds on the market place. However, several of them have some pretty big issues- the most being contango.

While it may sound like a funny word, contango can lead to underperformance and even losses in an ETF. For investors wanting to take the commodity plunge, understanding the concept is vital to long-term success.

Funny Word - Big Issue
For investors wanting to own ETFs that use futures contracts, they better get know the concept of contango. By definition, contango occurs when the price of futures contract is above the expected future spot price. This creates an upward sloping curve for future commodity prices over time. Commonly, the reason behind this phenomenon may be due to the desire of people to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today. Storing barrels of oil, tanks of natural or even bushels of corn isn't a cheap proposition and the costs have to be passed down the line. The reverse state of contango is called backwardation.

Contango in the commodities markets is a normal occurrence and investors need to understand that it isn't a bad thing. The effect has little effect on returns if as an investor you purchase individual futures contracts, hold them until expiration or trade them.

However, depending on how some ETFs are structured, contango can cause losses for the fund.

ETFs based only on current prices - meaning they own the future contract for the current month - lose money if a market is in contango because they have to buy the higher-priced, longer-dated contract and sell the cheaper spot month. For example, if the ETF is holding natural gas futures contracts for March, at some point it will have to roll them over to April contracts. If the March contract is worth $2 and the April contract is worth $3, they are technically selling low and buying high.

Two of the most popular commodity futures based ETFS: the United States Natural Gas Fund (ARCA:UNG) and the United States Crude Oil Fund (ARCA:USO) have consistently been losers for investors based on the issues of contango. While the funds are fine for daily trading, holding them long term has spelled disaster. UNG has actually returned a whopping -95% since its inception.

What to do
As you can see, commodity ETFs based solely on buying the future contract for the next month can lead to loses. However, the concept of contango shouldn't prevent you from adding commodities to a portfolio. Like much of the ETF industry, commodity products are always changing and innovating.

To that end, several fund sponsors have unveiled new products specifically designed to tackle the contango problem head on. ETFs like the PowerShares DB Oil (ARCA:DBO) or UBS E-TRACS DJ UBS Commodity Index 2-4-6 Blended Futures ETN (ARCA:BLND) use flexible-futures trading strategies - such as blending contracts or optimized roll yields - instead of just automatically rolling to the next month's contract to create contango fighting returns. So far, many of these products have been successful at tracking rising commodity prices better than traditional roll yield products.

Investors can also get physical for a few select commodities. Funds like the SPDR Gold Shares (ARCA:GLD) or the iShares Silver Trust (ARCA:SLV) actually hold bullion in a vault on behalf of investors. There are no futures contracts or contango to worry about. While current physical offerings are just limited to precious metals, both copper and aluminum have physically backed ETFs in registration.

By using some of the newer or physically-backed ETFs, investors can navigate the negative effects of contango.

The Bottom Line
With more investors seeking commodity exposure in their portfolios through ETFs, familiarizing themselves with the concept of contango is critical. The commonplace occurrence can mean big trouble and big losses if investors pick the wrong fund for their long term portfolios.

At the time of writing, Aaron Levitt did not own any shares in any company mentioned in this article.

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