HardAssetsInvestor

Futures: The Three Sources Of Returns

Most people who are new to the commodities market assume that futures contracts track the prices they hear about on the evening news: If the price of gold goes up, their gold futures investment should do well.

It turns out to be more interesting -- and profitable -- than that. The reality is that there are actually three components that determine how your futures investment performs: spot prices, the roll yield and collateral interest. And each one is critically important.

Spot Price: The Basics

Making money on the spot price is easy to understand. If you buy a gold future at $650/ounce, and the price of gold jumps to $850/ounce, you're sitting pretty. Add in leverage, and you can be sitting on major profits.

Of course, if you got it wrong, math knows no mercy.

The Roll Yield

The roll yield is a bit more complicated to understand, but it's absolutely critical to your returns.

Futures contracts aren't like stocks: They expire on a monthly or quarterly basis. If you want to have a steady position, you have to "roll" from one contract to another, selling the expiring contract and buying the new one.

That's all fine and good, except the next month's contract doesn't usually cost the same as the current contract. It may cost more, or it may cost less.

If it costs more, you effectively lose money. In the business, we say the market is in "contango."

If it costs less, you effectively make money. In this situation, we say the market is "backwardated."

Contango is bad, backwardation is good: Got it?

The profit or loss you make from rolling your contracts each month is called the "roll yield," and it has historically been the single most important contributor to commodity returns ... more important even than the spot price. The impacts can be huge: At one point last year, the oil market was in such steep contango that the oil price had to rise 35% per year just for investors to break even.

How do you know if a market is in contango or backwardation? The best way is to head to one of the commodities markets (like the NYMEX) and pull up the current prices for contracts. If the second-month contract is more expensive than the current-month contract, you're in contango.

Contango is bad and backwardation is good. Got it?

Interest Income

The last big component of your real return is from interest income. Remember, you (or your mutual fund or ETF) only put up a fraction of your investment when you bought the futures: just $2,500 to buy $75,000 worth of gold.

Most funds and investors will take the rest of that cash and invest it somewhere safe, like in Treasuries or TIPS. This can give a big boost to your total returns: If short-term T-bills are paying 5 percent a year, you're halfway to double-digit returns before you've even broken a sweat.

Adding It Up

So what matters? Spot price, roll yield or collateral?

In a word, all three. Below is a chart showing the returns of the Goldman Sachs Commodity Index, a diversified basket of commodity futures. As you can see, in each time period, the three different returns had vastly different impacts for investors.

Just look at the 1980s! Spot commodity prices actually declined, but investors in the GSCI still earned 10+ percent returns, thanks to the collateral income and the benefit of the roll yield.

Conversely, in 2006, nasty contango in the energy markets meant a difficult roll yield that absolutely killed investors.

Currently, in the fall of 2007, the oil markets are in backwardation and most other commodity markets are in contango. But that could change at any time. And as always, smart investors will be paying attention.

Next Up? ETNs, ETFs and TRACKRS

In our next Hard Assets University article, we'll take a look at different commodity investment vehicles like mutual funds, ETFs, ETNs and TRACKRs, and see how each one fits into your investment strategy.