What are contango and backwardation, and what impact do they have on volatility-linked ETPs?
For every futures contract, there is a "futures curve": a plot of the prices of its individual contracts across all the various maturities. (This is analogous to "term structure" for interest rates or bond yields.) The slope of this curve - meaning, how price changes by maturity date - can be particularly relevant for exchange-traded products that track indexes of VIX futures contracts.
Futures are said to be in "contango" when contracts with longer-dated maturities trade at a premium to those with shorter-dated maturities. If the VIX were at 10, for instance, and the front month contract was priced at 11, and the second month contract at 12, the slope of the futures curve will be positive, and we would say the market is in contango.
On the other hand, futures are said to be in "backwardation" when contracts with longer-dated maturities trade at a discount to those with shorter-dated maturities. In this case, the slope of the futures curve will be negative.
Specific to VIX futures, when the futures curve is in contango, it means that near-term investor expectations of volatility are lower than those for a later date - investors think market volatility will be higher in six months than it will be tomorrow. VIX futures exhibit contango a majority of the time. However, VIX futures can move into backwardation, meaning investor expectations of volatility in the near term are higher than those for a later date - investors think market volatility will be higher tomorrow than it will be in six months. Backwardation is unusual in VIX futures, but it can arise during volatility spikes in the S&P 500.
When contango persists, it can result in a negative roll yield, which creates performance drag on a long volatility-linked ETP.
On the other hand, an inverse-volatility-linked ETP may benefit from persistent contango, essentially "harvesting" the roll cost a long-volatility investor would incur.