Be Cautious with Commodities

The access to this asset class provided by ETFs can benefit all market participants but there's plenty of confusion around

Ben Johnson 25 March, 2010 | 1:37PM
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The success of ETFs can be attributed to a number of factors. Low costs, intraday liquidity, and instant exposure to wide and narrow slices of an array of markets have all played a role in the category's explosive growth. One of the fastest growing segments of the ETF market is the commodity group. ETFs tracking commodity benchmarks have been ballooning both in number and assets, driven by the widespread adoption of commodities as a long-term holding and the newfound accessibility of these markets.

Commodities can play a role in a balanced asset allocation. A track record of providing uncorrelated returns has won the commodity category a place in many portfolios as an attractive diversifier in a mix with stocks, bonds and cash. ETFs have made a category that was once the realm of large institutional investors accessible to the masses. But, as with everything, investors should be aware of what they are actually buying when they go shopping for a commodity-focused ETF. A look behind these funds' label will show that they are often not what they seem.

Odds are It's Not Spot
Spot prices are the stuff of commodity headlines, the numbers called out every day in the financial media, and represent the prices for immediate payment and delivery on everything from aluminium to zinc. Many investors are under the impression that commodity ETFs will provide them exposure to changes in the spot market prices of copper, corn, oil, pork bellies, etc. In the vast majority of cases, this simply isn't so. Unless you are buying a fund that takes physical possession of the underlying commodity, you are not receiving direct exposure to spot market prices (and even in the case of physical holdings, you are not receiving "pure" spot price exposure). There are currently ETFs tracking gold, silver, platinum and palladium that directly hold their reference metals. Given that these metals are fairly simple to standardise and inexpensive to store (you don't have to feed and water gold bullion the way you do livestock), they lend themselves well to a physical holding structure.

A Look into the Futures
So if the commodity ETF doesn't track a commodity's spot price movements and it isn't taking physical possession of the underlying commodity, what exactly are you getting? Most commodity ETFs provide exposure to movements in the prices of futures contracts trading a single commodity (oil, natural gas, copper, etc.) or an index comprised of single-commodity futures (DJ-UBS Commodity Index, Deutsche Bank Liquid Commodities Index, etc.). Futures contracts represent an agreement to buy or sell a commodity at a pre-determined date and at a pre-determined price. Futures prices will differ from spot prices based on a number of different factors including storage costs (paying for oil tankers, grain silos, etc.) and seasonal demand patterns (natural gas futures might rise above spot prices in anticipation of a cold winter), amongst others. As such, the returns on ETFs investing in commodity futures will typically differ from the spot price movements of the underlying commodity or basket of commodities.

Roll Returns
Further distorting the performance between the prices of commodity futures funds and spot price movements is the fact that commodity funds must periodically roll into new futures contracts as existing contracts expire. For instance, a fund that provides exposure to 1 month forward Brent oil will have to sell out of one month's futures contracts and buy the subsequent month's contracts on a regular basis.

The regular rolling of futures contracts results in what is known as roll returns or roll yield. This is the source of the majority of the difference between spot price returns and the returns experienced by investors in commodity futures. Roll return can be attributed to the price difference between the current period's futures contracts and the price of the subsequent periods' contracts into which the fund or index is to be rolled. Roll returns can be either positive or negative depending on the slope of the futures curve for the commodity or index in question. If the futures curve is upward sloping--that is each subsequent months' futures price is progressively higher (known as contango)--this will result in a negative roll yield. How does this work? Each period, the fund will sell relatively low-priced contracts and buy relatively higher-priced contracts further out on the futures curve. The process of selling low and buying high results in negative roll yield. This phenomenon has been prevalent of late, as many commodities futures markets have been in contango for the past couple of years.

But what if the futures curve is downward sloping, or backwardated? Backwardation results in a positive roll yield. Each period, the fund will sell relatively higher-priced contracts and buy relatively low-priced ones.

What are the Implications of Roll Yield?
Roll yield will lead the returns of commodity futures indices and funds to diverge from commodities' spot price performance. As you can see in the table below, while oil prices rose sharply in 2009 (represented below by the spot price returns of West Texas Intermediate Crude Oil and Brent Crude), futures-based ETFs (represented below by ETF Securities' Brent Oil 1 month and Crude Oil ETCs) generated relatively lacklustre returns. However, this is not attributable to a flaw in these funds' design. They performed exactly as advertised. Comparing the returns on ETFS Crude Oil ETC and its benchmark index--the DJ-UBS Crude Oil Sub-Index--we can see that the fund tracked its benchmark fairly closely, with a 1% tracking difference (0.49% of which is accounted for by the fund's total expense ratio). The wide divergence in returns here is due to the fact that the oil futures curve had a steep upward slope through 2009, resulting in negative roll returns which weighed on these funds' performance.

How do you Deal with Roll Yield?
Creating a better way to replicate the spot price performance of a broader swath of commodities is the Holy Grail for commodity fund providers. Given the costs of storage, a physical replication fund for oil, natural gas, or agricultural products is an unlikely solution. However, there are a few unique options currently on the menu that seek to tackle some of the challenges associated with investing in commodities through futures markets.

The first fix is to simply invest in futures that are further out (say, three months) on the curve. Investing in longer-dated futures contracts can do a bit to mute the effects of regular rolling, which are typically most pronounced in front month futures. However, this strategy isn't foolproof, and real results are mixed at best, as you can see in the table below.


There are more advanced strategies available that actively seek to minimise roll losses when futures markets are in contango and maximise roll gains when they are in backwardation. For instance, db x-trackers offer futures-based commodities ETFs (see this table) that track indices which use a rules-based quantitative strategy to manage the process of rolling futures positions in their component commodities. The track record of these funds' benchmark roll-optimised (termed "Optimum Yield" or "OY" by Deutsche Bank) indices versus their non-optimised counterparts is impressive. The level of diversification these funds offer, coupled with a proven measure to manage roll returns makes these funds an attractive option for a portion of one's commodity allocation, in our opinion.

Buyer Beware
ETFs have opened commodity markets to a broader swath of investors. While the democratisation of this asset class can benefit all market participants, it has been accompanied by a good deal of confusion amongst those new to the sector and to the ETFs that track it. Investors should be wary of commodity-focused ETFs. Those looking for spot price exposure must recognise that spot prices do not represent an investable return. The closest proxy for spot price performance comes through physical holdings--which are presently limited to precious metals funds in the ETF category. Outside physical holdings, ETF investors are purchasing exposure to the movements in commodity futures prices. Investing in commodities through futures introduces unique considerations and sources of return (both positive and negative)--most notably roll returns. For a long-term position in commodities, we think that some of the best ETF options in the category include funds like those on offer from db x-trackers, which offer exposure to a broad, well-diversified basket of commodities in tandem with a tested strategy for managing roll returns.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.

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