HardAssetsInvestor

Written by Matt Hougan  |

December 02, 2008

Tough Outlook For Commodity Indexes

Details

There are times when commodity futures are a good bet; this is not one of those times. [Corrected]

• Huge contango in the markets
• No collateral return
• Why commodity stocks are a better bet

[Correction: In an earlier version of this article, the author used the DB Commodity Index and the PowerShares DB Commodity Index ETF (NYSEArca: DBC) as the proxy for how roll yield could hurt a commodity portfolio. Unlike "classic" commodity indexes like the S&P GSCI, however, the DB Commodity Index actually uses an optimized roll strategy designed to mitigate the impact of contango. Specifically, the index has the flexibility to invest in futures further out the futures curve if they offer more attractive pricing, which may give it an advantage in the current climate.

The corrected article follows below.]

Investors in commodity futures - and that includes all the people who own commodity futures ETFs - are in a world of hurt.

It's bad enough that spot commodity prices are crashing. Oil is down nearly $100 from its highs, and copper and other commodities are down 50% or more.

But commodity investors have lived through falling commodity prices before and come out more or less OK. In the 1980s, for instance, the S&P GSCI Spot Commodity Index delivered -1.37% annualized returns for the entire decade. But investors in the S&P GSCI Total Return Index actually earned 10.67% annualized returns.

How?

Because, as we've written before, there are three sources of return on a fully collateralized commodity futures index:

• Spot return: Changes in the spot prices for the underlying commodities.
• Collateral return (cash yield): Interest income on collateral. Futures are inherently leveraged, so a fund only needs to put up 5%-10% margin to gain its commodity exposure, with the remainder invested in safe collateral, typically short-term Treasuries.
• Roll yield: The return (or loss) gained from "rolling over" a futures portfolio, i.e., selling contracts that expire this month and replacing them with contracts that expire next month (or next quarter, depending on the commodity). Contracts may be either more or less expensive, creating either a positive roll yield (a situation called "backwardation") or a negative roll yield (a situation called "contango").

Each of these returns is critical to commodity futures index returns. The table below shows the roll each type of return made to the S&P GSCI Commodity Index over the past few decades. (The data is only through March 31, 2007, as that is the latest data I have available.)

Not surprisingly, the best situation for commodity futures indexes is when all three types of returns are working together, as happened in the 1970s, when the spot return, cash yield and roll yield were all positive. But even when one of the returns falters - as the spot return did in the 1980s and 1990s, and the roll yield did as well in the 1990s - investors still did OK, because the other sources of return provided ballast.

Unfortunately, investors find themselves in exactly the opposite position today: Everything is working against them. In a major way.

Spot prices, as mentioned, have collapsed, and show little sign of a rebound.

The cash yield from collateral is terrible too: Three-month Treasuries were yielding 0.01% at the end of November, according to the Federal Reserve. (No, that is not a misprint.)

And the roll yield? That is awful too.