HardAssetsInvestor

Written by HardAssetsInvestor.com  |

January 02, 2007

Dancing The Contango

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Contango is such a nice-sounding word.

Do you contango?

Of course, it’s lovely.

But contango is anything but nice for futures investors; lately, it’s been destroying returns.

• Contango-driven losses in 2006
• The roll yield turns oil sour
• The index effect meets the commodities market?

Contango is such a nice-sounding word.

Do you contango?

Of course, it’s lovely.

But as any commodity futures investor knows, contango is anything but nice: it’s a mean little bugger that steals your returns when you’re not looking.

Ask any investor who’s been active in the market recently. While spot prices have gone up and up and up, deep and persistent contango in many futures markets has undermined the positive returns.

In 2005, for instance, the Goldman Sachs Commodity Index (GSCI) delivered a 39.05 percent return on a spot basis – pretty good. But the contango-ed roll yield rolled back 12.55 percent of that return before investors ever saw it.

2006 has been even worse: while the spot market has slipped a marginal 1 percent, the negative roll yield has hammered investors with a 13.46 percent loss. For naïve investors who thought they heard the cash register ring every time the price of oil ticked up on the evening news, those results may have come as a nasty surprise.

Figure 1 shows the spot return, roll yield and cash yield for commodities over the past 35 years. The roll yield was a strong contributor to returns in the 1970s and 1980s, but it turned negative during the new millennium ... and really negative after 2005.

The problem is oil and other energy products, which make up more than three-quarters of the GSCI Index. Historically, energy markets have traded in backwardation, while metals and agricultural markets traded in contango. But the oil markets have been stuck deep in the mud of contango for nearly two years now, while, surprisingly, industrial metals and agricultural products have shifted ever closer to backwardation.

The Index Effect Meets The Commodities Market

There are a thousand theories about what’s driving the persistent contango in the energy markets. One theory is that we are in the midst of a secular adjustment to higher oil prices, and that the futures markets are just slow to catch up.

Another (increasingly popular) perception is that the rush of assets into commodity indexed products --- managed futures assets rose from $40 billion in 2001 to $140 billion in 2005 -- has driven up premiums on near-term contracts. After all, these indexes typically buy the near-month contract and then roll it over each and every month, mechanically. The theory suggests that this has created an “index effect” that artificially pushes up the price of near-term contracts.

Equity investors will be familiar with this idea: during the late-1990s, stocks being added to the S&P 500 Index routinely experienced an artificial and temporary rise in price prior to entry into the index. Traders anticipated that the huge sum of indexed assets would be forced to buy the stock on the day it entered the index, and they “front-ran” these purchases in an attempt to make a profit.

By one measure, traders are doing the same in the commodities space. According to the Commodity Futures Trading Commission (CFTC), there has been a huge rise in the use of non-commercial trading spreads that aim to profit on contango situations. In 2001, there were around 70,000 spread positions outstanding at the New York Board of Trade; today, that number is closer to 260,000.

Indexers Explore Alternatives

With many markets in deep contango, investors and index developers alike are increasingly looking for ways to improve returns (and to sidestep this “index effect”). While some are choosing active strategies, others are tweaking traditional index approaches in an attempt to outsmart the market.

One of the pioneers in this space is Deutsche Bank, developer of the $600 million PowerShares DB Commodity Index exchange-traded fund (ETF). That popular fund initially launched with a straight-forward indexing methodology, buying near-term contracts on six commodity futures and rolling them each month.

But the persistent contango in many markets forced Deutsche Bank to look for an alternative, and they have created what’s known as an “optimum yield strategy.” This strategy gives the index the flexibility to choose the contract with the best roll yield; it can look as far as thirteen months out the time spectrum for the contract with the best implied roll yield. The strategy takes on duration risk, but Deutsche Bank says that it also boosts returns: From December 1988 to May 2006, Deutsche Bank says that adding this optimum yield strategy has raised the annualized return from its core commodity index from 9.20 percent to 9.72 percent, while boosting the Sharpe ratio from 0.49 to 0.63.

In a similar vein, the ETF Securities Oil ETFs, which trade in London and other markets, have stopped buying near-month contracts, and are instead purchasing futures dates two-months out.

Institutional managers are getting even more creative. Jeffries, for instance, has managed its “Jeffries Commodity Performance Index” product for pension plans and institutional investors since 2003. The index is a long-only, passive product, but it incorporates tweaks to the composition, rebalancing and rollover schedules in an attempt to generate alpha. Jeffries claims that its enhanced index approaches have been generated 2-3 percent excess annual returns over the past few years, while lowering risk.

(Even straight commodity indexes differ in their approaches, and they are starting to emphasize those differences. For instance, the GSCI allows the weights of different components to float, and never rebalances. But the Dow Jones AIG Commodity Index limits the size of different commodity groups in the index; for instance, energy can account for no more than one-third of the benchmark. As a result, the index rebalances each year, selling commodities that have gone up and buying commodities that have gone down. As a result, the Dow Jones AIG has a higher historical Sharpe ratio than the GSCI: 0.75 vs. 0.53 for February 1991-January 2006, according to Rabobank.)

The Flipside

Will all these strategies work in the long-term? Ultimately, the answer must be no – there’s no free lunch in the financial markets. But the blind rush of assets into traditional commodity indexed products may have created a situation that can be exploited by smart strategies ... a least over the short-term.

The “index effect” was very real for equity investors in the S&P 500 during the late-1990s, and traders were able to capture excess returns by playing on this market anomaly. Over time, however, the trade got crowded, and the excess returns slowly but steadily disappeared. The same thing is likely to happen in the commodities market. In the meantime, however, the scramble is on.