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Dancing The Contango

The other day I received an investment note from a long-time reader of ours, Mark Schumacher. Mark is the portfolio manager at ThinkGrowth out in the great state of Massachussets.

As we've said many times, Chris and I are primarily speculators. Mr. Schumacher on the other hand is more conservative, focusing on growth and income. However, his most recent note really piqued my interest, in part because our friend Harris Kupperman has put this type of trade on as well, with varying success.

In general, Mark has looked at the relationship between ETF's that track the price of commodities, and the tracking error and contango that almost inevitably occurs. This also presents itself in the VIX (Kuppy's chosen target). We can make a lot of money by shorting these ETF's, but you have to make sure you understand the underlying relationships, it's not as easy as simply selling them and checking back in a few months.

I thought that more than a few of our readers would appreciate Mark's take on this, so I rang him up and asked if I could reprint the article, with a few comments thrown in for good measure. He graciously agreed, so enjoy!


It would be difficult to overstate the importance of innovation. Most everyone understands that new thinking, methods and products are vital at all levels of society especially in our globally competitive world. When an idea has scale potential there are plenty of incentives for risk-takers to pursue their long-shot ideas hoping to beat the odds. This we know.

What's less understood and never celebrated is the critical role that failure plays in the innovation process. Thousands of relatively quick and modest-sized product and business failures are necessary for an inventive society to work because failure redirects inputs - labor and capital - in the most effective manner possible. Policies that hinder or delay the realization of failure misallocate resources, creating a less adaptable, productive, innovative society.

In my field, a big recent innovation has been Exchange Traded Notes and Funds (I'll simply refer to them all as ETFs). They are low-cost products that attempt to track narrowly-defined assets including commodities, stocks, bonds and currencies. ETFs empower investors by broadening the pool of investment vehicles but there's a fly in the ointment, which will bring us back to the word failure because some of these products have serious flaws. They simply fail to track their target (especially when the target is a commodity) and that creates a low-risk investment opportunity for us.

The primary reason some ETFs have high tracking errors is because they do not take physical possession of the underlying target asset, instead, they own futures contracts. They try to mirror price changes using these contracts which give them the right to buy a fixed quantity at a set price at a future date. The contracts' values fluctuate (and thus the ETFs value fluctuates) along with market price changes in the underlying asset. If you own an oil futures contract and oil prices rise the contract becomes more valuable so the ETF's share price will also rise. So far, no problem.

But futures contracts have expiration dates and as those dates approach the contract owner (the ETF) needs to sell them and buy new contracts with expiration dates that are further out, otherwise, the owner will take delivery (via a warehouse receipt) which nobody wants due to storage and insurance costs, slippage, spoilage and lack of liquidity. Tracking error is primarily derived from rolling (selling and rebuying) these contracts because the new contracts purchased are usually more expensive than the old ones being sold. When this is the case (which it is more than 80% of the time for some assets) the asset's price is said to be in contango.

Over time contango (upward sloping price curve) destroys the value of some ETFs, especially when a) contango is steep, b) the ETFs use leverage or are inverse and c) when the ETFs roll their contracts frequently, like every month as some do. I call the loss generated from rolling these contracts 'roll-decay.' The investment opportunity is to simply short the ETFs with lots of Roll Decay.

Shorting is when you lose money when the price rises but make money when the price declines, which is exactly what you would expect to happen to ETFs undergoing a great deal of roll decay. Sometimes these shorts should be hedged to eliminate market risk, which I will cover in an upcoming article on Market Neutral Investing. (Note: We'll look at publishing Mark's follow-up articles as well for our readers)

There are many ETFs that track their targets fairly well and therefore do NOT offer a compelling investment opportunity for us. My research has uncovered several high-profile ETFs with big roll decay over all time periods and conditions making them great short candidates. Let's take a look at my two favorites.

Example #1: Natural Gas (/NG) is the target asset represented by the green line. UNG is the tracking ETF that is our short candidate represented by the purple line.

Over 6 months natural gas is up +9.1% while UNG is down -10.4%. That's 19.5% decay versus the target in just six months. If there was no roll decay we would have lost 9.1% on our short, instead, we would have made just over 10%. So even if the price of the target asset moves against us we can still generate a profit if the cumulative roll decay is large enough. Thank you contango!

Chart 1 - Contango

Looking at the one year chart, natural gas is up +18.9% while UNG is down -22.5%. That's 41.5% decay in one year. That's a pretty strong 19% move against us in just one year, yet we would have still logged a 22% profit from our short! It's getting better...

Chart 2 - Contango

Over 2 years natural gas is down -30% while UNG is down -64%. That's only 34% decay over two years (less than the 41.5% decay over one year) but our total profit increased to 64%, because we would have benefited from both roll decay and the decline in natural gas prices. Notice that in all three examples the tracking was tight in the beginning but over time the gap expands significantly. This is compounding working in our favor.

Chart 3 - Contango

Example #2: S&P 500 Volatility Index (VIX) is the target asset represented by the green line. VXX is the tracking ETF that is our short candidate represented by the purple line.

Over 6 months the volatility index is down -24.6% while VXX is down -51.8%. That's 27.2% decay in just six months. If there was no roll decay we would have made about 24% on our short, instead, we would have made nearly 52% because the profit we earn on the decay gets added to the profit from the target asset's declining price! (Note: This is the play Kuppy was talking about as well in his post Designed to Fail.

Chart 4 - Contango

Looking at the one year chart, the volatility index is down -24.4% (same percentage decline we had over six months) while VXX is down -76%. That's 51.6% decay in one year. Are you dancing with excitement yet?

Chart 5 - Contango

Over 2 years the target volatility index is down a modest -15.7% but VXX is down -79.3%. That's 63.6% decay in two years. You get the idea now, right?

Chart 6 - Contango

Why are these products still on the market?

It would appear that these two ETFs are destined to lose all their investors money on their way to zero and termination. They are clearly 'designed to fail' and will wipe out every shareholder in short order, right? Well, not so fast. Today UNG and VXX each have over one billion in assets under management and shareholders have not been running for the exit. What gives?

It turns out that these ETFs actually do a decent job over short time frames (days or a few weeks) in meeting their stated objectives to track an underlying asset "on a daily basis." We can see the tight tracking at the start of each period in all our charts. This "daily tracking" fills the demand in two niches - investors wanting a near-term hedge and investors wanting a near-term speculation. These niches offer fairly stable demand at a high enough level for the ETFs to be profitable for the issuers and have market staying power. They aren't going anywhere which is music we can dance to!

Monitoring Contango

Contango is dynamic. Each day the amount of roll decay changes and over a period of weeks or months it can steepen, flatten out or flip into backwardation (a downward sloping price curve) so I monitor it for the products I have shorted - currently the above two ETFs. There will be times when it makes sense to close a short and watch from the sidelines as well as times to increase a short position. These adjustments will affect our total returns but they are marginal in comparison to the profits available from roll decay.

Bottom line is that a bit of maintenance is required to resize the positions as they grow or shrink as a percentage of your portfolio, as well as when the slope of the price curve changes.

How is this low-risk investing?

Shorting these decaying products is low-risk when the investment is sized properly (not too big) due to the wide margin of safety. When in contango the only way to lose money shorting is if there is a big spike in the target's price shortly after you put the position on such that you have not had time to benefit from the daily decay. Even then you can recoup your loss if either the target's price subsequently reseeds or the price stays elevated while the roll decay eats away at your loss as time passes.

At times this margin of safety can be impressive. For example, the current roll decay for VXX is 12% (the long-term average is 7%) per month. VXX turns its entire portfolio over every month rolling the front month contract into the 2nd month. It's contango won't stay at 12% but even the historical average of 7% a month is impressive by any standard.

What's the Catch?

There is no catch but there are a few things to be aware of. Most importantly, select target assets not likely to experience rising prices and select tracking ETFs with a history of high decay and don't open your short position after a big move down unless it is quite small. Use ETFs with lots of liquidity; it can be difficult or impossible to short some ETFs especially the smaller and leveraged ones. Finally, you should have a plan for dealing with the inevitable price spikes and brief periods of backwardation.

In my opinion, these innovative and fairly recently introduced ETFs have opened up a unique opportunity to make significant returns using low-risk investment tactics provided the targets are chosen carefully and positions are sized properly and monitored. This is something I am excited about - low-risk, high-return is the holy grail of investing.


This is a strategy that almost anyone can employ, but as Mark points out, it's not risk-free, especially short-term. Mark asked me to make it clear that he doesn't believe NOW is the right time to put this trade on. UNG's contango is nil, and the VIX index is near its historical lows.

The goal with this post is to explain a smart trading strategy that can be executed when the timing is right. If someone insists on putting on a trade like this now, Mark's suggestion is to short VXZ rather than VXX. VXZ is the mid-term VIX tracker owning months 4 through 7. The contango between the 4th and 7th month is 11.0% today, which is a 3.67% monthly roll-decay. This is because this ETF cycles four times a year, not 12 times like VXX does. The long-term average historical decay in VXZ is 2 - 4% (a little less than half VXX's historical monthly decay of 7%).

Also, as Mark pointed out above, a rapidly rising underlying asset can cause this trade to backfire. For those that believe we may see hyperinflation, assets like natural gas and the stockmarket in general under that scenario will rise rapidly. Being short one of these ETFs would be unfortunate in that case. On the other hand, if you think we are headed for deflation, then you'll want to investigate this type of trade with vigor.

- Mark

"Often the difference between a successful person and a failure is not one has better abilities or ideas, but the courage that one has to bet on one's ideas, to take a calculated risk - and to act." - Andre Malraux

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This is an interview piece that was wrapped in an article format by myself and Mr. Schumacher. I have not been compensated.