Warning: Three ETFs That Could Be Crippled By Contango

The surge in popularity of ETFs is often credited with bringing buy-and-hold investors a cost-efficient alternative to traditional actively-managed mutual funds. But ETFs are also responsible for bringing several asset classes previously available only to the largest and most sophisticated individuals and institutions within reach of investors on all levels.

While this "democratization" of investing is generally a positive development, it does come with some potential pitfalls.  The specifics of the exposure to some of these hard-to-access asset classes is available to investors willing to do the research, but it isn't always quite what those who only do cursory research may imagine.

Contango: A Four Letter Word To ETF Investors

In many cases, ownership of the underlying asset to which ETFs offer exposure is either impossible (e.g., equity market volatility) or impractical / prohibitively expensive (e.g., crude oil or live cattle). So in many cases, the best way to gain exposure to a particular asset is through a futures-based strategy. Many exchange-traded products buy "near month" futures contracts, and to avoid ever taking physical possession of the underlying, they sell the current month contract before it expires and buy into the next month's process. This process, referred to as "rolling forward," can result in the ETF either forking out more cash is the price for second month contracts is higher than the current month (contango) or taking in cash is the opposite is true (backwardation). See this article for a more in-depth look at how the roll process works.

So when the slope of the futures curve is steep and upward sloping, investors essentially put themselves in a hole from the beginning, needing a rise in prices just to break even. It should be noted that a number of factors can cause a contangoed market, including market expectations for rising prices, or to reflect the costs associated with storing the underlying asset.

Three primary factors affect the prices of ETFs that utilize a futures-based strategy: 1) changes in the spot price, 2) interest income on cash, and 3) the "roll yield." Below, we highlight three ETFs and ETNs that could face some strong headwinds from the third of these factors in coming months.

3. iPath S&P 500 VIX Short-Term Futures ETN (VXX: 25.01 -0.24 -0.95%)

VXX is an exchange-traded note designed to provide access to equity market volatility through futures on the CBOE Volatility Index (better known as the "VIX"). Specifically, the underlying index offers exposure to a daily rolling long position in the first and second month VIX futures contracts. Since hitting an all time high above 80 in November 2008, the VIX has steadily retreated below its long-term average 20. With a still fragile economic recovery facing a number of serious obstacles�including a potential debt crisis in Europe, and still climbing unemployment in the U.S.�a bet on an upswing in market volatility is beginning to look pretty attractive.

VXX offers a way to make this play, but investors should be aware of the steep slope of the VIX futures curve before jumping in. March futures were recently trading at a 4% premium to spot prices, with April contracts trading another 15% above March futures. Since its inception in January 2009, VXX has maintained a strong correlation to the VIX, but overall results have been materially different: the futures-based ETN is down about 75% since its launch, while the VIX Index has declined by about 55% over that period (see VIX ETFs: Crushed By Contango).

2. iPath Dow Jones-UBS Livestock Subindex Total Return ETN (COW: 29.38 +0.03 +0.10%)

This cleverly-named ETN is linked to an index comprised of futures contracts on lean hogs and live cattle, making it a potentially attractive option for investors looking to bet on rising food prices. While the futures market for live cattle, which makes up about 60% of the underlying index, is currently in slight backwardation, the market for lean hog futures is on the steep side.

May contracts were recently trading at a 7% hike from near-month futures, with another 5% jump to June levels:

 

1. iPath Dow Jones-UBS Grains Subindex Total Return ETN (JJG: 36.296 -0.794 -2.14%)

Premium To Prior Contract
Contract	Soybeans	Corn	Wheat
March	n/a	n/a	n/a
May	1.1%	3.0%	2.5%
July	0.9%	2.8%	3.1%

Despite recent data showing that core CPI prices actually fell in January for the first time in nearly 30 years, many investors continue to be very concerned over the prospect of inflation. Some see an investment in agriculture products through JJG or COW as an effective way to hedge against inflation, since food prices are often among the first to rise when CPI heads higher.

The iPath Grains ETN (JJG) has three major components: soybeans (about 40% of the index), corn (36%), and wheat (24). At present, the futures curves for all three of these commodities are upward sloping, likely reflecting both expectations for rising food prices and the costs incurred in storage.

None of the three ETFs highlighted above should necessarily be avoided just because of the contango in related futures markets. But investors should, as always, know what they're getting into.