Commodities indexes may not repeat

by Levi Folk | November 20, 2006

Commodity index funds have been swamped with investor dollars in recent years as record returns and asset class diversification have tempted mainstream investors away from bread-and-butter long-only equity investments.

However, strong gains in base commodity prices mask an important driver of commodity index returns -- the roll yield -- which has turned negative in recent years and could create problems for investors if the commodity markets take a breather, as appears to be happening.

To fully understand commodity-index returns, investors need to grasp the dynamics of passive commodity index investing. The Goldman Sachs commodity index (GSCI) is invested in 24 different commodities, with weights based on world production rates of the various commodities.

The Deutsche Bank commodity index (DBCI) is invested in only six basic commodities: crude oil, heating oil, aluminum, gold, wheat and corn. Apparently this mix provides greater liquidity, without forgoing much in the way of diversification. Rather than owning the commodities outright, the indexes gain exposure to the underlying commodities by investing in commodity futures.

Futures contracts on the underlying commodities require the buyer to take delivery of the physical commodity when the contract expires. The indexes therefore sell the contracts prior to maturity to gain exposure to commodity-price movements without having to own the physical commodity. This exposure is achieved by rolling the futures position as it nears maturity into a later-dated contract.

The structure of the futures curve therefore plays an important part in the total return of the commodity indexes. Historically, futures contracts tend to trade cheaper than the spot price, a situation called backwardation. Thus, investors would earn a positive roll yield on the trade by buying the cheaper contract and selling for a premium as it becomes more expensive. Note that this yield is independent of the other source of return, which is derived from changes in commodity prices across the futures curve.

In recent years, that roll yield has turned negative, however, because of a change in the shape of the futures curve: Futures prices began trading higher than spot prices for many commodities, a situation referred to as contango. The implication of a contango market is that index investors face a continual loss on the futures trade.

There is much speculation that the massive inflow of retail money into the asset class has distorted the structure of the market, turning the roll yield negative.

Goldman Sachs estimates that roughly US$100-billion is invested in the various commodity indexes, with more than US$60-billion in the GSCI alone. Prior to 2002, when it was first suggested that commodity markets possibly had entered a "super cycle" spurred by rising demand from China and supply constraints, total assets invested across these indexes never surpassed the US$10-billion mark.

Neither Goldman Sachs nor Deutsche Bank could say just how much the roll yield contributes to the returns on their respective indexes, but it is clear that the yield has turned negative on average in recent years after having been positive, on average, historically.

In response to the costs of contango for commodity-index investing, Deutsche Bank has created an "optimum yield" version of the Deutsche Bank commodity index to minimize the costs of contango and maximize the benefits of backwardation on its index returns, says Kevin Rich, chief executive of DB Commodity Services Ltd. LLC.

The return on the optimum-yield index at 14.2% this year is more than double the 6.6% return for the DBCI, which uses a fixed future rolling strategy, with the difference being largely attributed to the costs of the negative roll on the futures contract. Incidentally, the year-to-date return on the GSCI is negative, a 13.2% loss.

This is not merely a case of splitting hairs, given the solid returns on the indexes over the past three years (the GSCI three-year return is 11.6%, annualized). The roll yield is important and has played a large part in the total return on the GSCI over the past decade, according to John Dizard, writing in a recent Financial Times article. Historically, the roll yield is positive on average, according to Dizard, perhaps as much as two-thirds of the time for the oil market, for example, according to Kevin Rich of DB.

Perhaps the more salient point is that as base metals and energy prices have come off their highs, the yield associated with many of these futures investments is negative. If markets remain in contango, investors will need a consistent appreciation of commodity prices to make money.

Strong historical returns and low correlations to broad equity indexes make commodity-index investing appealing. However, if historical-return drivers on these indexes are changing, then history may not be a great guide for making investment decisions.