Some investors, however, have expressed frustration over gaps between exchange-traded commodity products and hypothetical spot returns [see also How to Trade Natural Gas Futures: UNG and Beyond].

This confusion arises from a lack of education and diligence on the part of investors who assume that commodity funds will deliver returns that correspond to spot prices. While some precious metals funds seek to deliver returns that correspond to spot, achieving this type of exposure is not possible in many markets; the physical properties of resources such as oil, corn, and natural gas make physical replication impossible.

Thus many commodity products invest in futures contracts linked to the actual commodity, allowing for exposure to resources without taking physical possession. What some have failed to grasp is that there are nuances related to futures-based investment strategies that can have a material impact on bottom-line returns [see also 25 Ways To Invest In Natural Gas].

Contango has become a four-letter word among commodity investors, the culprit responsible for disappointing returns from futures-based products. Yet many investors fail to understand exactly what contango is and how it impacts futures prices–concepts that anyone interested in exposure to commodities should understand.

Perhaps the most widely cited example of the adverse impact of contango is the United States Natural Gas Fund (UNG), a product that invests primarily in front-month futures contracts. UNG’s returns have differed significantly from a hypothetical return on spot natural gas over the last several years as a result of the futures-based strategy implemented. UNG rolls its holdings near the middle of each month, selling the near-month contract and buying the next month contract.

To illustrate how contango can impact the returns of a hypothetical natural gas fund, we’ll walk through the trades a fund might make over the course of several months in order to meet its investment objective. Let’s assume that our natural gas fund has $100 million in assets on January 1st, which it invests in near-month natural gas NYMEX futures contracts (i.e., contracts for February delivery). We’ll assume the fund rolls holdings on the 15th of every month, selling near-month contracts and buying the second month contracts [see also The Ultimate Guide To Natural Gas Investing].

On January 1st, spot natural gas is trading at $4.00/million BTU. We’ll assume the contract for February delivery is trading at $4.10, reflecting both the costs of storing the underlying resource until that point and market expectations over future price movements. NYMEX natural gas contracts represent 10,000 mmBtu, thus the fund in question would buy 2,439 contracts at $41,000 each.

Fast forward to January 15th, when the fund begins to roll its holdings. Spot natural gas is still trading at $4.00, but the price of February futures has dropped to $4.05. The fund sells its contracts, generating proceeds of $98,780,488. It uses those proceeds to invest in March contracts, which are trading at $4.10. The fund’s exposure to natural gas contracts is now represented by 2,409 March contracts [see also Crude Oil Guide: Brent Vs. WTI, What’s The Difference?].

Spot natural gas prices have held steady at $4.00/mmBtu, but the fund has already lost 1.2% of its value through the “roll” process.

We’ll jump forward to mid-February, the point at which our hypothetical fund would sell its March contracts and roll into April futures. Spot gas prices have added more than 1% over the last month, climbing to $4.05. With expiration nearing, March contracts are still trading at $4.10 and April futures are slightly more expensive at $4.15. In order to maintain exposure, our fund sells March contracts for no gain and rolls into April futures.

The value of the fund remains the same over this month, though natural gas prices appreciated. Since the beginning of the year, spot natural gas prices are now up approximately1.3% while our fund is down 1.2%.

We’ll carry the example forward for one more month to complete the illustration. Come the Ides of March, spot natural gas prices have dropped back down to $4.00. April futures are now trading at $4.05 and May contracts are priced at $4.10. As the fund rolls, the number of contracts held continues to decline–a nuance of futures investing in contangoed markets [see also 25 Ways To Invest In Crude Oil].

After less than three months, natural gas prices are at the beginning-of-year levels. But our natural gas futures investment vehicle has lost about 3.6% of its value by rolling from cheap contracts to more expensive contracts on a regular basis. Carrying this process out on a recurring basis can result in investors incurring a significant “roll yield” in order to maintain their exposure to commodity prices.

Many investors focusing on establishing exposure to commodities concentrate on the impact that changes in supply and demand will have on spot natural resource prices. While these considerations are obviously important, it’s critical to also take into account the impact that the lope of the futures curve can have on returns. As the example above highlighted, contangoed markets can create strong headwinds for many commodity funds and commodity ETFs, even when the degree of contango is moderate and the holding period is relatively brief [see also Beyond UNG: Three Intruiging ETFs To Play Natural Gas].

It should be noted that the presence of contango in futures markets shouldn’t necessarily deter investors from a product. There are countless examples of contangoed commodity products posting big gains despite flying into the wind. Education is the key to successful investing, particularly when it comes to commodities.

Disclosure: No positions at time of writing.