By: Neil Kotecha, BNY Mellon & AllAboutAlpha.com Editorial Board
A recent topic in many financial publications has been the persistence of adverse market conditions facing commodity investors. Specifically, investors’ returns differ significantly from commodity price returns. The articles in these publications tend to illustrate the drag on total returns when unfavorable conditions result in negative roll yields. The importance of roll yields was highlighted in this AllAboutAlpha.com post by Keith Black from June 2008. Additionally, a more recent AAA post touched upon the impact investors may have on the market index.
Return Components of Commodity Futures
Because of the capital costs of holding commodities directly, investing is almost exclusively done using futures (exceptions include commodity producers, consumers, etc.). Commodity indices, ETFs, ETNs and mutual funds manage their portfolios very similarly when using futures contracts. For the most part, they construct the portfolio by purchasing near-dated futures contracts. As the contracts near maturity, they sell the contract at or near the spot price of the commodity and purchase new near-dated contracts, and then the process repeats itself. The frequency and magnitude of this roll leads to the importance of the yield it generates.
Unfortunately, investing in commodity futures contracts can be complicated since total returns are comprised of three return components:
- Collateral Yield: Futures contracts require very little collateralization (~10%). The remainder is frequently invested in high-quality, short-term instruments such as a 90-Day T-Bill. The yield from these investments is often very small relative to the total return and is known as the collateral yield.
- Spot Price Change/Yield: This represents the price change in the underlying commodity contract and is often quoted during a discussion of a commodity’s return. Investors are usually seeking exposure to these returns when choosing to invest in commodities.
- Roll Yield: This component of return is the focal point of the recent articles, and is a little more complicated. Commodity investors (e.g. indices, funds, etc.) tend to buy near-dated contracts (e.g. 1-month from expiration) and sell them just prior to settlement. The revenue generated is immediately used to purchase another near-dated contract to maintain exposure to the commodity. This process continues indefinitely and represents the roll yield (sale price less purchase price). If the subsequent purchase cost is less than the revenue gained from the sale, then the roll yield is positive; if the sale prices is less than the purchase price the roll yield is negative. A positive roll yield is referred to as backwardation while a negative yield is called contango.
Do Index Funds Contribute to Contango?
For decades, the principal parties involved in commodity markets were producers, consumers and large institutional investors who sought primarily to hedge their exposures. In the past 10 years, however, modest size institutions and retail investors have gained access to commodities markets through ETFs, ETNs and mutual funds. Each of these investment structures has taken advantage of the nearly limitless liquidity of the futures markets as investor interest and assets grew.
As assets grew, a theory developed that additional demand for the products would result in higher prices. To an extent this is rational; as the demand for near-dated contracts rose the forward curve would slope upward creating contango. At first glance, the following graph of S&P GSCI roll yields would appear to support this theory, however, upon closer inspection the relationship is far less clear.
The asset levels during the two worst periods of contango were $3.6 billion in October ‘06 and $22.3 billion in February ’09 . Both were well below the high of $52.2 billion in July ‘10 when the one month roll yield was -0.37%. Additionally, asset levels fell the most during the largest acceleration of contango between October ’08 and February ’09, indicating a potentially negative relationship between index demand for the contracts and contango.
The Decade of Contango
The last ten years have seen the commodities markets fluctuate significantly. Twelve-month spot price returns of the S&P GSCI Total Return Index have ranged from -49.26% (5/08-4/09) to +55.26% (02/02-01/03). The following points can be observed from 10 years of one-month total returns and roll yields:
- The GSCI has been in contango for most of the past 10 years.
- Spot price returns appear to be the primary contributor to total returns.
- The amount of contango varied but exceeded 2% infrequently.
- Recent roll yields appear reactionary rather than predictive to total returns.
- Maximum contango occurred in February ‘09 but the worst period was in October ‘08.
- A contangoed market does not preclude positive total returns.
With an unclear relationship between roll yields and total returns, it is premature to conclude that investors are irreparably harmed by a contangoed market. What’s more, the market environment does not appear to be permanently in contango, regardless of the demand caused by index funds.
A small amount of contango can add up to a substantial number when compounded monthly. This is particularly true as investors have experienced. That being said, it appears that the much of the impact on total returns is being driven primarily on spot price yields, rather than contango.