Commodity indexes track futures contracts, which are not securities and which expire (or “mature”) after a specified period, typically several months. At that point, the commodity underlying the futures contract — be it 5,000 bushels of corn or 1,000 barrels of crude oil — is delivered by the seller to the buyer.
Of course, investors do not want truckloads of grain or freighters of fuel, so if they have bought contracts in anticipation of rising prices they need to sell them before the delivery day.
If they want to remain in the market, moreover, they need to buy futures contracts that still have a life span ahead of them. This process is called the “roll” because investors are rolling their money out of the expiring contract and into another that will terminate at some point down the road.
Backward and forward
Investors in indexed commodity vehicles do not have to handle the roll; the portfolio managers do that for them. But the roll itself — apart from whether commodity prices are rising or falling — has a great deal to do with the returns investors get. As a result, those returns sometimes are different than what investors might expect.
It all depends on the prices of the contracts being rolled out of and into. If you sell an $80 contract and roll into a $75 contract, you made $5, or 6%, on top of whatever the commodity price did. But if you sell an $80 contract and have to buy an $85 contract to stay in the market, you lose 6%. Whether positive or negative, this is the “roll yield.”
When contracts whose expiration is further into the future are lower priced than the soon-to-be expiring (or “nearby” or “front month”) contract, that market is said to be in “backwardation.” When those more distant contracts are higher priced, the market is in “contango.” Both terms apparently originated on the London Stock Exchange in the 19th Century, but meant different things then.
Commodity indexes are comprised by these markets. For instance, the Dow Jones UBS Commodity Index covers 19 commodity markets, of which 15 currently are in contango and four are in backwardation. This count suggests that when the index rolls into new contracts each month, its returns are penalized by contango.
That is true, but oversimplified. For one thing, not all contracts in the index roll every month. Some roll only four times a year. For another, sometimes the roll is into the contract that matures next and sometimes it is into a more-distant contract – all according to the index’s methodology.
This detail is important, because neither backwardation nor contango show up as straight-line price decreases or increases. The price curves across the contract months often flatten out or even reverse. And from month to month the backwardation or contango can become steeper or flatter, or flip from one to the other.
Supply and demand
It’s important to understand why these conditions exist. Backwardation and contango represent the market’s current expectations of future supply and demand for the individual commodities.
For example, crude oil is in contango because global demand is rising faster than oil companies can find new supplies for the foreseeable future. Cotton is in backwardation because current high prices, caused by weather-reduced crops last year, should encourage farmers to plant more this year and thus increase the supply.
An indexed investor following the commodity markets might be puzzled by his quarter-end statement. In the first three months of this year, the Dow Jones UBS Commodity Index rose 6.94% based on the 19 components’ price movements relative to their weights in the index. However, the roll yields in those three months were negative, reducing the return to 4.41%.
But that is not the end of it. Buying futures requires only about 10% or so of the value of the contract to be paid in cash initially; if prices fall, more cash is required. Meanwhile, the unspent money (the difference between the “list value” of the contract — the number of specified commodity units times the price — and the amount of cash paid at purchase) earns the auction rate of Treasury Bills. That is currently a minuscule amount, but someday it might amount to something.
All those measurements together produce the total return to the investor, which is what the broker reports. In the case of the Dow Jones UBS Commodity Index in the first quarter, that total return was 4.45%. An investor who diligently followed the course of commodity markets during the quarter ends up with a return that is one-third less than the markets seemed to deliver.
Is this a rip-off? No, it is just the way an indexed, futures-based commodity fund has to work. Investors who play the futures market directly face the same problem, except they can be more nimble and roll into a distant contract with a flatter contango curve, thereby softening the roll yield hit.
Some newly developed commodity indexes are designed to do the same thing, and as long as they do not become popular they can successfully whittle contango. The more distant-maturing contracts almost always have very low liquidity and could not absorb a lot of assets flowing in from a big indexed commodity fund. Trading costs are higher in low-liquidity contracts, too.
So, while you might reduce the effects of contango on your portfolio, you cannot eliminate it while benefiting from exposure to commodities. What benefits? Portfolio diversification is one. Over the decade ended March 31, a combination of 55% stocks, 35% bonds and 10% commodities delivered a bigger return with similar risk to a blend of 60% stocks and 40% bonds.
Commodities also are a hedge against inflation, which lots of people seem to think lies in wait — and may already be starting. Not a perfect hedge, but better than that afforded by the traditional asset classes. According to Francisco Blanch, head of global commodity research at Bank of America Merrill Lynch, commodity prices are roughly 75% correlated to U.S. inflation.
Whether these benefits outweigh contango-clipped returns is a matter of personal opinion. But it is clear that index-based commodity investment vehicles have opened this asset class to a far broader spectrum of investors than ever before. That is tremendously important in a world where demand for commodities will be generated by billions of people striving to raise their standards of living.
John Prestbo is editor and executive director of Dow Jones Indexes, a joint venture of CME Group, Inc., and Dow Jones & Co., Inc., publisher of MarketWatch. Jeffrey Fernandez contributed research to this report.