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There's Something to the Contango ETNs

Michael Johnston

Yesterday I wrote about some of the frustrations shared by investors who have sought exposure to natural gas in recent years and highlighted Natural Gas Futures Contango ETN due June 14, 2041 GASZ as a potentially interesting tool to profit from the contango that has crippled ETFs such as United States Natural Gas Fund UNG over the past several months. Today I'm returning to dive a bit deeper into what is a very innovative and, as it turns out, profitable strategy behind this ETN and several similar products offered by UBS.

GASZ maintains net long exposure to natural gas futures contracts, making it similar to UNG, iPath Dow Jones-UBS Natural Gas Subindex Total Return ETN GAZ and other natural gas exchange-traded products in that regard. But there are two components of the exposure -- namely, a long position in midterm futures contracts (which tend to be less severely impacted by contango) and a short position in short-term contracts -- that mean that this ETN is essentially playing the house by selling short-term futures contracts, profiting from the steep contango at the near-term end of the futures curve. If UNG is flying into stiff headwinds, the short portion of the GASZ portfolio has those same winds at its back.

Shorting futures contracts is obviously risky, which is where the long position in midterm contracts comes in. That serves to limit the downside risk if the underlying asset (natural gas, in this case) suddenly surges. The result is a relatively low-risk product that profits from structural inefficiencies in these markets while protecting investors from huge swings in price.

GASZ and similar UBS ETNs' combination of both long and short positions in substantially similar asset classes (e.g., midterm gas futures and short-term gas futures), creates a product with relatively low volatility. While the VIX, natural gas, and crude oil are subject to huge swings in price over a short period of time, the ETNs that make up this unique product suite experience relatively low volatility. And they've been managing to climb steadily higher in recent months regardless of the movements in the underlying assets.

GASZ, which targets natural gas futures, has added about 18% so far on the year. That's a particularly impressive figure because natural gas prices have been plummeting, recently falling below $2 for the first time in years. UNG, the most popular tool for playing natural gas (with more than $700 million in assets under management), has already lost about 40% on the year. The stellar results so far in 2012 for GASZ illustrate how significant the impact of contango can be on futures-based strategies.

Oil Futures Contango ETN due June 14, 2041 OILZ , which focuses on crude oil futures contracts, has posted a gain of about 3% this year. While that's far less impressive than the numbers posted by GASZ, it's an important validation to the merits of the underlying strategy. Unlike natural gas, crude oil prices have been climbing in 2012 (despite a recent pullback). That translated into losses in the short position in short-term WTI contracts, but the net long exposure maintained through the mid-dated contracts has been more than enough to offset those losses. Traditional long-only futures-based oil exchange-traded products have returned about 3% to 5% on the year, meaning that OILZ is keeping pace despite a less-than-ideal environment for the underlying strategy.

Finally, UBS AG Exchange Traded Access Securities (E-TRACS) XVIX has posted a gain of about 7% so far in 2012. Again, that's very impressive considering that the VIX has declined significantly this year and that products focusing on short-term VIX futures contracts, such as iPath S&P 500 VIX Short-Term Futures ETN VXX , are down close to 45%. It illustrates the power of selling futures contracts at the short end of the maturity curve.

For investors looking to expand their portfolio beyond traditional stocks and bonds, these ETNs represent intriguing opportunities for adding alternatives that can both enhance returns and bring diversification benefits. There's now a sufficient track record over which to evaluate the efficiency of these long/short combinations, and the results to date have been quite encouraging.


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