Retail investors may be considering making investments into commodities through Exchange Traded Funds (ETFs) yet in our experience, they may lack a full understanding of the potential hidden costs associated with these investment vehicles.
If one could invest directly into the underlying commodity at the spot price, the conclusions reached in this article might be different. However, to invest in the spot price one needs to take (or be able to take) physical delivery of the underlying commodity. Whilst this might be practical for certain commodities such as gold or silver, it certainly isn’t practical for oil, corn wheat or gas etc. Retail investors will therefore typically look to an ETF to gain access to their commodity of choice. It is for this reason that they need to understand the differences between the commodity spot prices and the rolling futures contract.
The performance of a commodity ETF is largely dependent on three variables:
1) Changes in the spot price of the underlying commodity,
2) Interest income on un-invested cash, and
3) The ‘roll yield’
While the first two are easily understood by most investors, the roll yield is potentially more troubling. To help us better understand first some definitions:
Contango is a term used in the futures market to describe an upward sloping forward curve. This could be considered the normal state of play and such a forward curve is said to be "in contango".
This is the situation where, and the amount by which, the price of a commodity for future delivery is higher than the spot price, or a far future delivery price higher than a nearer future delivery.
The opposite market condition to contango is known as "backwardation".
However, where the market is in contango, an index-based investor could lose money irrespective of whether the current price appears to be favourable. The reason for this is that futures contracts expire after a fixed period and need to be renewed. So, the long term investor pays a price for constantly rolling over a contract to remain invested. Since the investor has to pay a premium to move into the following monthly contract, a profit can only be achieved if the positive price moves outweigh the losses generated by this roll process. I.e. the increases in the underlying price are greater than the cost of remaining invested.
Therefore retail investors looking at the relatively low price of a particular commodity today such as oil for example may consider that it appears to represent an attractive buying opportunity, however, the state of the futures market may mean that they could still generate a loss just because of the negative roll experience.
Retail investors are discovering that a commodity ETF is therefore not really a direct play on the spot price of the underlying commodity at all- it is, instead, a play on a combination of the spot price the forward prices and the relationship between these spot and forward prices i.e. the slope of the futures curve. For an investor who is investing long-term into a commodity ETF the maintenance of the contango will cause impairment of the value of the ETF in relation to spot price – whereas, any mitigation of the contango situation (including a shift to a flatter curve or backwardation) will by contrast enhance the performance of their ETF investment.
By way of an illustration, look at the graph comparing the futures contract with the spot price of sugar between April 2004 and December 2008:
As you can see, in this example, the impact of the roll yield is very significant and you would be down 126% compared to the spot price.
Of course the reverse is also true and a large contributor to differences in commodity futures returns has been the return derived from rolling futures contracts before they expire because this roll return is positive when futures markets are “backwardated”.
Many markets (such as those for energy contracts) have been consistently backwardated in the past.
The message here is that investors considering investing in a commodity ETF should most definitely be interested in the shape of the curve of forward contracts, and specifically whether it is in contango or not.
At first sight, commodity investments appear to have some interesting investment characteristics. However, they are totally reliant, in terms of price performance, on what the next man will pay for them. There may be a risk premium embedded in them, but it is far from clear as to what extent this can disappear during inflows of “hot money”. That is to say that the delicate balance between hedgers and speculators can be easily unbalanced, and investor’s capital chasing risk premium can cause the risk premium to no longer exist.
Remember that past performance is no guarantee of future returns and just because commodity investment may have delivered good returns for investors in the past, does not mean that the same will be true in the future.
Finally, analysis in 2004 found the average excess return from commodities is not reliably different to zero and there is also little evidence to support commodities’ reputation as a diversifier and inflation hedge.
What this means is that, on average, is that an investment in commodities does not reliably offer an expected premium above cash rates. Investment is therefore pure speculation, for every long there is a short. For you to win on your bet that the price will rise, I have to lose my bet that the price will fall. Over the long run, the average expected return from all the bets I place is zero, less my costs of engaging in the process.
Commodity investments might make sense if you can buy at close to the spot price and avoid the storage and insurance costs. This is where options like the Perth Mint Certificate Program give investors a sporting chance of making a direct investment into the underlying commodity.
 ‘Commodity Futures in Portfolios’, Truman A. Clark, December 2004