HardAssetsInvestor

Written by Lara Crigger  |

April 02, 2010

George Rahal: Contango Has No Effect On Commodity Returns

Details

The shape of the futures curve has no impact on commodity returns, says the founder of Vista CTA, LLC.

• Why contango doesn't matter—but roll does
• What to look for in an ideal commodity index
• Why you don't want to be ‘where the action is’

 

We've all heard the old saw: Contango is a bad time to buy commodities futures. But that's not exactly true, says George Rahal, founder of Vista CTA, LLC. In fact, he says, the shape of the futures curve has very little to do with commodity investment returns.

George Rahal is a commodity trading adviser with over 20 years' experience in the commodities markets. Prior to May 2009, Rahal was co-founder and managing member of Longview Funds Management, where he was the firm's sole investment adviser, and developed the Longview Commodity indexes. He has also worked as a stock, bond and commodities broker, as well as a natural gas and electricity trader and risk manager for a number of large energy firms.

Recently, HAI Associate Editor Lara Crigger sat down with Rahal to discuss the influence contango has—or doesn't have—in the commodities markets, including why turnover matters more than curve shape, what investors should look for in an ideal commodity index, and why he doesn't want to be "where the action is."

 

Crigger: The common wisdom is that contango is a bad time to buy commodities futures. But you recently wrote a paper demonstrating that this isn't true. Can you tell us a little about your findings?

Rahal: That maxim is repeated so often! I wonder if people maybe believe things without looking at their returns. Based purely on buying and holding back-month commodities, if you measure your returns, you find that contango or backwardation (or, more generally, curve shape) has no apparent relationship to whether you're going to have a gain or a loss.

Another simpler way to look at it is: The great majority of all commodities are usually in contango, and for the last 10 years, commodity markets have had a bump. The archetypical commodity—gold—is always in contango; it's never in backwardation. And a lot of long-term gold holders have done very well. That alone brings into question the premise.

I think many people look at crude oil and heating oil, and wrongfully infer the whole spectrum from these. These are the two big markets that are subject to interruptions and shut-down costs. But when you test out that concept with crude oil over the past 10 years, it turns out that even when the market's in contango, we've had significant price appreciation.

So, I think this is all obvious to people who trade the stuff, but maybe it's not as obvious to institutions or other researchers who aren't really testing this concept every day.

Crigger: So what about futures-based commodities indexes then? If contango or backwardation doesn't influence returns, then is it safe to buy and hold these indexes for long periods of time?

Rahal: I believe a properly constructed index should be part of an asset-allocated portfolio. The fact that the commodity markets have this characteristic of curve shape, it's something we find that throws people who don't know commodities. They may look at the bond market and see that there are times when the yield curve can invert, where short-term interest rates become higher than long-term interest rates. But that's not a predictor of profitable investments either.

Basically, in general, anything you can observe and measure today will not necessarily be a reliable predictor of returns tomorrow. That's just a fundamental theorem: Markets are unpredictable.

Crigger: So if this is the case, why have we seen such terrible returns in long-only, futures-based indexes and ETFs? UNG [the U.S. Natural Gas Fund] comes immediately to mind, but that's only the worst case—there are plenty more examples available.

Rahal: The class of indexes you're referring to all have a similar problem in methodology or construction: They're spot indexes. That's a problem. When you create an index that is continually buying and selling, and is frequently in the market—quarterly in the case of the ags, and bimonthly for most of the major indexes—there's just too much trading. It's too much turnover.

An index should have two characteristics: It should be able to benchmark its market, to be representative; and it has to represent the interests of long-term investors. So the fact that these are spot indexes is a problem.

I think if you look at the returns of back-month indexes, or long-dated indexes, or volatility-based indexes, you will see that they've had very positive returns over the long haul. They compare very well to equity returns and other investment class returns. Frankly, they've outperformed the prevailing commodity indexes, if you look at them side by side.