Acquired contango roll

What Is Acquired Contango Roll?

Acquired contango roll refers to the negative impact on returns that occurs when an investor or a fund holding futures contracts must "roll over" expiring contracts into new, higher-priced contracts in a market condition known as contango. This phenomenon is a critical aspect of understanding returns in commodity markets and other asset classes where derivatives are widely used. When a market is in contango, the price of a futures contract for a future delivery date is higher than the current spot price or the price of nearer-term contracts.³⁴ The "acquired" aspect emphasizes that this is a cost incurred by positions that continuously maintain exposure to a commodity or asset through rolling futures positions. The persistent nature of acquired contango roll can significantly erode returns over time.

History and Origin

The concept of contango itself has been observed in commodity markets for centuries, often tied to the cost of carry, such as storage, insurance, and financing expenses for physical commodities.³³ The formal recognition and analysis of "roll yield" (or "roll return"), which encompasses both positive returns from backwardation and negative returns from contango, gained prominence with the increasing sophistication of futures markets and the rise of financial instruments like exchange-traded funds (ETFs) that provide exposure to commodities. As these investment vehicles became popular, particularly in the 2000s, investors began to more acutely experience and scrutinize the effects of acquired contango roll on their overall returns. The mechanics of constantly rolling futures positions, as highlighted by CME Group, became a key area of study for market participants seeking to understand the full spectrum of returns from futures investing.³¹, ³²

Key Takeaways

• Acquired contango roll represents a negative return generated when futures contracts are rolled from a lower-priced, expiring contract to a higher-priced, longer-dated contract in a contango market.
• This cost primarily affects investors or funds that maintain continuous exposure to an underlying asset through futures.
• Contango is typically characterized by an upward-sloping futures curve, where prices for future delivery are higher than current or nearer-term prices.²⁹, ³⁰
• The impact of acquired contango roll can significantly diminish long-term returns, especially in commodity sectors prone to persistent contango.²⁷, ²⁸
• Understanding this phenomenon is crucial for effective portfolio diversification and managing risk in futures-based investments.

Formula and Calculation

The acquired contango roll is often quantified as part of the total roll yield. Roll yield is the profit or loss generated from rolling a futures contract before its expiration. When the market is in contango, the roll yield is negative, indicating an acquired contango roll.

The calculation of roll yield (and thus the impact of acquired contango roll) can be understood as the difference between the expiring front-month futures price and the price of the next futures contract, relative to the expiring contract's price.

Let:

• ( F_{near} ) = Price of the near-term (expiring) futures contract
• ( F_{far} ) = Price of the far-term (next) futures contract

The Negative Roll Yield (Acquired Contango Roll) can be expressed as:

If ( F_{far} ) > ( F_{near} ) (a contango market), the result will be a negative value, representing the cost incurred from the acquired contango roll. This reflects the investor selling a relatively cheaper expiring contract and buying a relatively more expensive next-month contract to maintain their position.²⁶

Interpreting the Acquired Contango Roll

Interpreting the acquired contango roll involves understanding its implications for investment performance. A persistent negative acquired contango roll suggests that the underlying market is in a structural state where rolling futures positions will consistently incur costs. This is particularly common in commodity markets where storage, insurance, and financing contribute to the cost of carry, making longer-dated futures more expensive.²⁴, ²⁵

When the acquired contango roll is significant, it can lead to a divergence between the performance of a futures-based investment and the movement of the underlying spot price of the commodity or asset. Investors might observe that even if the spot price of a commodity rises, their futures-based investment may underperform or even lose money due to the ongoing costs of rolling contracts in contango. This phenomenon is often discussed in the context of market sentiment and supply-demand dynamics, where expectations of future abundance or high holding costs drive the contango structure.²², ²³

Hypothetical Example

Consider an investor holding futures contracts for crude oil. Suppose the current spot price of crude oil is $80 per barrel. The one-month futures contract is trading at $81, and the two-month futures contract is trading at $82. This market is in contango.²¹

An investor's fund holds the one-month crude oil futures contract. As the expiration date approaches, the fund needs to roll its position to maintain exposure. It sells the one-month contract at $81 and simultaneously buys the two-month contract at $82.

In this scenario, the fund incurs a cost of $1 per barrel (the $82 purchase price minus the $81 sale price). This $1 represents the acquired contango roll for that rolling period. If the fund holds 1,000 contracts, each representing 1,000 barrels, the total cost for this single roll would be $1,000 (1,000 barrels/contract * $1/barrel * 1,000 contracts). This roll process would repeat monthly, accumulating the effect of the acquired contango roll over time, impacting the overall return of the investment, regardless of the spot price movement.

Practical Applications

Acquired contango roll has significant practical applications in how investors approach commodity markets and other futures-linked investments. For funds that track commodity indices, such as many exchange-traded funds (ETFs) and Exchange Traded Notes (ETNs), the acquired contango roll directly impacts their performance. These funds typically maintain continuous exposure by regularly rolling expiring front-month contracts into later-dated ones.¹⁹, ²⁰

For example, if a crude oil ETF constantly rolls contracts in a contango market, it will experience a drag on returns. This "roll cost" can cause the ETF to underperform the actual movements of the underlying commodity's spot price.¹⁸ Investors engaged in hedging strategies using futures must also account for the acquired contango roll, as it can affect the effectiveness and cost of their hedges. Understanding this concept allows investors to make informed decisions about their asset allocation and choose investment vehicles that might employ strategies to mitigate the effects of contango, such as those that invest further out on the futures curve or use active management.¹⁶, ¹⁷ Regulatory bodies like the Commodity Futures Trading Commission (CFTC) oversee these markets, ensuring transparency and integrity, which implicitly includes the fair pricing and functioning of such roll mechanisms.¹⁵

Limitations and Criticisms

While acquired contango roll is a well-understood market phenomenon, it presents several limitations and criticisms for investors. One primary concern is the potential for significant long-term capital erosion, particularly for passive commodity exchange-traded funds that are obligated to roll contracts regardless of market conditions. Even if the underlying commodity's spot price appreciates, the negative roll yield from consistent acquired contango roll can lead to a poor investment outcome.¹³, ¹⁴

Critics argue that this aspect makes certain commodity investments unsuitable for long-term buy-and-hold strategies, as the structural costs can outweigh potential gains from price appreciation.¹² Furthermore, while some actively managed funds attempt to mitigate the effects of acquired contango roll by employing dynamic rolling strategies or investing in contracts further out on the curve, these strategies are not guaranteed to eliminate the impact entirely and may introduce other risks.¹⁰, ¹¹ The complexity of forecasting the future shape of the futures curve and the unpredictable nature of market sentiment mean that investors cannot reliably predict the severity or duration of acquired contango roll.

Acquired Contango Roll vs. Roll Yield

Acquired contango roll is a specific outcome of the broader concept of roll yield. Roll yield refers to the profit or loss generated when an expiring futures contract is replaced with a new one. This yield can be either positive or negative, depending on the market structure.

Essentially, acquired contango roll is the specific negative result of roll yield that materializes when futures markets are in a state of contango. It signifies the expense investors bear to maintain a continuous futures position in such a market.

FAQs

What causes a market to be in contango?

A market typically enters contango when the futures price of a commodity is higher than its spot price. This often occurs due to the cost of carry, which includes expenses like storage, insurance, and financing for the physical commodity.⁹ Expectations of future supply surpluses or consistent demand can also contribute to a contango market structure.⁸

How does acquired contango roll affect investment returns?

Acquired contango roll can significantly reduce returns for investments that rely on rolling futures contracts, such as many commodity exchange-traded funds. Even if the underlying commodity's spot price increases, the continuous cost of selling cheaper expiring contracts and buying more expensive new ones can lead to an overall negative performance for the investor.⁶, ⁷

Can investors profit from contango?

While acquired contango roll implies a cost for long positions, experienced traders and speculators may attempt to profit from contango through arbitrage strategies or by taking short positions. However, such strategies involve considerable risk and are typically suited for sophisticated investors.⁵

Is acquired contango roll always present in commodity markets?

No, acquired contango roll is not always present. The opposite market condition is called backwardation, where future prices are lower than the spot price. In backwardation, rolling futures contracts can generate a positive roll yield. Market conditions, including supply and demand dynamics, dictate whether a market is in contango or backwardation.³, ⁴

How can investors mitigate the impact of acquired contango roll?

Some investors may choose to invest in physically-backed commodity products that do not use futures. Alternatively, certain futures-based funds employ "optimized" or "dynamic" rolling strategies that aim to minimize the effects of acquired contango roll by selecting futures contracts with different maturities or adjusting their roll frequency. However, these strategies do not eliminate the risk entirely and may introduce other complexities.¹, ²