Contango concerns? Key factors to consider when evaluating commodity ETFs

by: , Chief Investment Officer and Managing Director | IndexIQ; Dan Petersen, CAIA®, Director, Product Management, IndexIQ

Key takeaways:

  • As the recent record-high levels of contango have demonstrated, there are many pitfalls associated with futures-based commodities investing, however the IQ Global Resources ETF (GRES) seeks to avoid many of these risks.
  • Commodities have historically been one of the better performing asset classes in the early stages of an economic recovery.
  • GRES has a 4-star overall Morningstar Rating™ based on the risk-adjusted returns from among 117 Natural Resources funds as of 4/30/2020.

The extreme excess supply of oil caused by the Saudi-Russia price war in combination with a world-wide halt in consumption due to the Covid-19 lockdowns has led to a historic crash in oil price crashes and a contangoed curve of a lifetime.

Contango is when the future prices of a commodity are higher than current month’s price. As you can see in the chart below, as of 4/30/2020 (the yellow line), the July 2020 futures contract is trading almost 20% higher than the June 2020 contract. For an investor that has to sell the June contracts to purchase the July contracts, the cost would be a whopping 20%! The August contracts are an additional 13% higher than July.

Oil futures curve in % over spot price

Source: Bloomberg, as of 4/30/2020.

There are many pitfalls associated with futures-based commodity ETFs including:

  • the cost of rolling contracts due to contango (see the oil chart above),
  • CME (Chicago Mercantile Exchange) position limits on what percentage of the open interest in a contract, or total number of outstanding derivative contracts that have not been settled, that a single investor is allowed to own. This prevents from any one fund, trader, or investor from gaining a controlling interest over the market.
  • limits on share issuance for the ETF can cause the ETF arbitrage mechanism to breakdown, and allow the ETF to trade like a closed-end fund,
  • excessive concentration in the energy sector, and
  • overly high correlation to the broader equity markets.

While some futures-based commodities ETFs are experiencing difficulty in this environment, as an equities-based commodity ETF, the IQ Global Resources ETF (GRES) has no direct exposure to futures contracts rolling month-to-month. This means that GRES is not subject to CME limits on position exposure or on how many shares of the ETF can be created. GRES also limits its weight in energy holdings to help ensure better diversification, and features equity hedges to help reduce the equity market correlation.

As shown in the table below, GRES has demonstrated 3- and 5-year standard deviations closest to the commodity spot index, meaning that historically, the movement of its returns have been most similar commodities than commodity futures or the Morningstar peer group.  In regards to equities, its correlation has been closer to the commodities index than the peer group, meaning that GRES’ daily movements are more like commodities than the peer group. And with an equity beta closest to the commodity spot index than any other approach, GRES moves to the least degree with equity market volatility.

Source: Morningstar, as of 3/31/20. Equities are represented by the S&P 500. Past performance is not a guarantee of future results. It is not possible to invest directly in an index.

Commodities have historically been one of the better performing asset classes in the early stages of an economic recovery.  While no one can accurately predict when that will start, investors may want to start considering which ETF they would want to use. GRES was designed to avoid many of the risks associated with futures-based commodity ETFs and offers a compelling opportunity for clients seeking to invest in commodities to participate in the potential economic rebound in an efficient exposure that is closest to the risk/return characteristics of the commodity spot index.

About risk

Before considering an investment in the Fund, you should understand that you could lose money.

As the Fund’s investments are concentrated in the global resources sector, the value of its shares will be affected by factors specific to that sector and generally will fluctuate more widely than that of a fund which invests in a broad range of industries. The Fund is susceptible to foreign securities risk. Since the Fund invests in foreign markets, it will be subject to risk of loss not typically associated with domestic markets. Loss may result because of less foreign government regulation, less public information, less economic, political and social stability, or other factors. Investing in smaller companies involves special risks, including higher volatility and lower liquidity. Investing in mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. The Fund may experience a portfolio turnover rate of over 100% that will increase transaction costs and may generate short-term capital gains which are taxable.

CME (Chicago Mercantile Exchange) Group Inc. is an American markets company. It is the world’s largest financial derivatives exchange, and trades in asset classes that include agricultural products, currencies, energy, interest rates, metals, and stock indexes.

position limit is a preset level of ownership established by the U.S. Commodity Futures Trading Commission (CFTC) that limits the number of derivative contracts a trader, or any affiliated group of traders and investors may own. The limits are put in place to keep anyone from using derivatives to exercise undue control on a market.

The Bloomberg Commodity Spot Index measures the price movements of commodities included in the Bloomberg Commodity Index and select subindexes. It does not account for the effects of rolling futures contracts or the costs associated with holding physical commodities.

The Morningstar® Global Upstream Natural Resources Index provides exposure to 120 companies that have significant business operations in the ownership, management or production of natural resources in energy, agriculture, precious or industrial metals, timber, and water resources categories as indicated by Morningstar’s Global Equity Classification Structure.

The S&P 500 Index measures the stock performance of 500 large companies listed on stock exchanges in the United States.

The S&P Dynamic Futures Index follows a quantitative methodology to track the prices of a diversified portfolio of 24 commodity and financial futures contracts.

Beta is a measure of an investment’s volatility relative to the overall market. It is most often calculated using an investment’s movements relative to the S&P 500 Index over the trailing 12-month period.

Correlation measures the degree to which two securities move in relation to each other.

Standard deviation measures how widely dispersed a fund’s returns have been over a specified period of time. A high standard deviation indicates that the range is wide, implying greater potential for volatility.

The Morningstar Rating™ for funds, or “star rating”, is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product’s monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance (this does not include the effects of sales charges, loads, and redemption fees). The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods. For the period ending April 30, 2020, GRES was rated four stars overall based on the risk-adjusted returns from among 117 Natural Resources funds, four stars for the three-year period among 117 funds, four stars for the five-year period among 109 funds, and three stars for the 10-year period among 85 funds.

Consider the Fund’s investment objectives, risks, and charges and expenses carefully before investing. The prospectus and the statement of additional information include this and other relevant information about the Fund and are available by visiting nylinvestments.com/etfs or calling 888-474-7725. Read the prospectus carefully before investing.

Fund shares are not individually redeemable and will be issued and redeemed at their NAV only through certain authorized broker-dealers in large, specified blocks of shares called “creation units”, and otherwise, can be bought and sold only through exchange trading. Creation units are issued and redeemed principally in-kind.

“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. IndexIQ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs, and NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

© 2020 IndexIQ. All rights reserved. Any unauthorized use, disclosure, copying, dissemination, or redistribution of this information is strictly prohibited.

SMRU 1854728

Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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Dan Petersen, CAIA®

Director, Product Management, IndexIQ

Dan Petersen is a Product Manager at IndexIQ, responsible for developing actionable content as it pertains to the competitive landscape, analyzing fund usage in the latest market environment, and portfolio positioning for both individual portfolios and broader-based applications

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