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How Contango Creates Negative Roll Yield in Futures-Based ETFs

Article Quant Q&A · Author: jessica
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Summary

The document explains negative roll yield for a commodity ETF that uses futures to approximate spot exposure. As a held near-expiry contract approaches maturity, its price converges toward spot. In a contango curve, the next contract costs more than the expiring contract, so replacing the position requires paying more for comparable exposure. This recurring replacement cost is the mechanism behind negative roll yield; the ETF does not need to own physical spot commodities.

The discussion also distinguishes convergence of a particular futures contract toward spot from the behavior of the curve over successive expiries. It says there is no guarantee that a later contract will converge in a way that benefits a long-only investor, and describes persistent contango as potentially costly when rolling forward. The answer offers a qualitative explanation rather than a quantified return analysis. Actual outcomes depend on the instrument, roll schedule, curve changes, and spot-price moves, so contango alone does not establish an ETF’s total return.

Key ideas

  • A futures-based ETF can seek spot-like exposure without holding the physical commodity.
  • A futures contract generally approaches spot as its maturity gets closer.
  • In contango, buying a more expensive next contract to maintain exposure can create negative roll yield.
  • Convergence of one contract does not guarantee favorable returns across successive contracts.
  • An ETF’s total performance also depends on spot movements, curve changes, and its rolling process.

Tags

CommoditiesFuturesCarry
Full text
# ETF Negative Roll Yield


# ETF Negative Roll Yield












I have a quick question about the ETF Roll Yield. As we all know commodity ETF’s have struggled with contango (spot price is below futures prices on the term structure). Look at an ETF like USO which because of the contango in WTI has had negative roll yield even as WTI prices have rebounded since 2008.

Here is my question. Why does the roll yield even occur? If an ETF like the USO is long the spot why does it have to roll into a higher price contract? Wouldn’t the futures price and the spot eventually converge by the time the roll occurs? The future price is higher than the spot in a contango wouldn’t the spot have to move higher to reach the futures price? I mean the futures can decline to the spot but I don’t see how this affect you if your long the spot.

If the USO isn’t long the spot but further out oil contracts, what guarantees that futures price will converge to the spot in a contango curve? So contango doesn’t have to necessarily be a bad thing for a long commodity investor/etf.

## Answer by John (score 3, accepted)

https://quant.stackexchange.com/a/8854

The futures price goes to the spot price as time to maturity declines, not vice-versa. The difference is referred to as basis. That's not really what roll yield is about though. The roll yield aspect is that as the contracts the ETF holds are expiring, they are close to the spot price. However, the next futures contract's price is higher than the price of the futures contract you're in due to the effect of contango. So if you were to sell out of the closest futures contract to buy the next one, it would cost more to achieve the same exposure it had before.

## Answer by CHP (score 0)

https://quant.stackexchange.com/a/8890

> If an ETF like the USO is long the spot why does it have to roll into a higher price contract?

This is wrong. An ETF is not always long spot (at least not USO). ETF try to create spot returns by using first month future contract. Imagine the amount of storage space required by USO issuer to store all that spot oil.

> If the USO isn’t long the spot but further out oil contracts, what guarantees that futures price will converge to the spot in a contango curve?

There is no guarantee. But the forward curves of commodities tend to change very slowly. So during contango period, typically there are more buyers for forward month contract compared to spot and situation tends to continue over period of multiple futures contract expiries. During such a period, an ETF provider (or even just long only investor who gains exposure using futures contracts) will have to keep on buying the front month contract at higher price than typically where he/she would be able to sell at end of that contract expiry.

Contango is almost always bad for long only invesor.

Another classic example of ETF suffering due to contango is VXX.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.