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If you are a holder of one of the many futures-based commodity broad-basket mutual funds or exchange-traded products like (DBC), (GSG), (DJP) or (GCC), then an understanding of what drives the return on the futures contracts held in these products is critically important. In connection with this, one needs to understand just how different the return on a commodity future can be from a spot commodity. I say this because I think some of the motivations for investors to have commodities in their portfolios is somewhat compromised by the reality that commodity futures have under-performed spot commodities pretty dramatically over the last 15 years. At a minimum, I think holders of these products should at least question how much of their allocation should be devoted to commodities based on the analysis that follows below.

The S&P GSCI is among the most well-known indexes currently tracking broad commodity markets and will be the object lesson I use for this analysis. However, when you say S&P GSCI you are not being specific enough. There are actually three different indexes that are relevant when talking about the S&P GSCI: the spot, excess return, and total return indexes. The spot index measures the price movement of the underlying physical commodity. When people argue that commodities are an inflation hedge, this can sometimes be the erroneous point of reference. Unless you are a well-endowed person with the means and ability to own, store and trade a basket of physical commodities, this index is not the return you can expect on commodities. The excess return index measures the return you'll get from a buy-and-hold basket of commodity futures, which is much closer to the return an average investor can expect because it includes not only the spot price movements underlying the futures, but also the cost (or as we shall sometimes see the benefit) to rolling that futures position forward over time. However, it's the total return index which is what an investor in the S&P GSCI index can realistically expect because it also adds in the return from the cash collateral used to back up the notional value of the futures contracts held in the index.

From this you can see there are different components to the total return on a basket of commodity futures in line with the three different indexes I mentioned above. There is the spot return, the roll yield component, and the collateral yield component (really just U.S. Treasury Bills) that combined together give you the actual return on your commodity holding. By breaking down how the S&P GSCI total return index compares to the spot return index, I will argue that the financialization of commodities over the last 15 years and also the policy choices of the Federal Reserve have combined to create an environment where commodity investors will be forced to accept returns well below their expectations and a position that does not ultimately hedge inflation as well as they thought it could, barring some unforeseen global commodity price spike.

First, let's look at the GSCI spot and total return indexes going back to 1970, the earliest I could find data on the GSCI indexes. Below I've shown the total return index as well as the three component returns that comprise the total return index, each as their own performance series over time. Based on the whole data set, the total return index generated an annualized return of 8.96%, with the T-Bills generating 5.43%, the spot market adding 4.26%, and the futures roll deducting 0.73% each year. This data makes commodity futures look like a roaring success, and they have been if you have been invested since 1970. However, most futures-based commodity products that are out today did not get started until the late 90s at the earliest. While spot commodity prices took some wild rides in the late 70s and early 80s, for the large part they went relatively nowhere for the next 20 years, creating little incentive for money management firms to offer commodities on a broad scale (save for the most sophisticated investors). This is why I consider the full data set below to really be two different periods, one from 1970 until roughly 1998 (during which the majority of the GSCI total return comes from T-bills), and then a second from 1998 until the present (the period of time which most of today's commodity products have operated exclusively in).

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To this end, I recreated the above analysis for the period from 1998 until the present in the chart below. This data tell a much different story about commodity futures relative to spot commodities. For the full period, the GSCI total return yielded an annualized 6.53% while the GSCI spot index gave you 11.15% per year. That 4.6% annual difference adds up pretty significantly over the nearly 15 years in this set. Of that difference, T-Bills generate a return of 2.27% per year while the futures roll costs you 6.87% per year. That's a pound of flesh for sure. It's those two factors that have changed the most dramatically over the last 15 years and I think deserve more comment below.

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In the case of T-Bills, unless you have been living under a rock for the last 5 years, you will know that short-term interest rates have been at near-zero levels since the onset of the financial crisis. The logical extension is that T-Bills have been a complete non-factor for the GSCI total return index since 2008 (as a fun fact, the Citigroup 3-month T-Bill gave you a whopping 0.7 basis points of return in March…that's 0.007%). This leaves the impact of the futures roll as the big factor currently in why commodity futures lag spot commodities. Like I mentioned above, this effect has amounted to costing commodity investors 6.87% per year since 1998. This is due to the current state of contango for the majority of commodities comprising the GSCI. In contango, futures prices in general are above spot prices, so the implication is that as the futures come to expiration, their prices drop to match the current spot price. This negatively impacts the performance of all futures-based commodity funds.

A good question to ask is why contango has become so persistent in commodity markets since the late 90s, because if you look at the chart graphing the roll effect on the GSCI all the way back to 1970 this has not always been the case. In fact, for the better part of 3 decades from 1970 the roll effect was actually accretive to the return of the GSCI. This implies that commodity markets were, in fact, in a state of backwardation (futures prices below the spot price) for most of that time. I will provide a simple theory as to why commodities have been in a contango state for some time. I think it is the very creation and inflows of money into commodity funds (which hold futures) that has created the roll costs these funds implicitly bear. If you take a look at the chart below, I compare the change in the open interest of a select basket of commodity futures since 1998 to the cumulative effect of the roll return on the GSCI over the same time period. I am positing that the increase in open interest across commodities in this window is being driven largely by speculative flows from commodity funds. These inflows are in turn causing futures prices to rise relative to spot prices, creating a cost to rolling the futures contracts themselves. Of course, a dynamic working against this theory could be spot prices themselves. Periods of strong increases in spot prices could lead a futures market in contango to discount any further upside, as the up move anticipated by the futures market occurs. This could flatten the curve and remove contango from the market, implying that contango conditions (or lack thereof) have more to do with changes in spot prices and less to do with speculative money flows, though it could still be a combination of those two forces.

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Another chart below gives the contribution of the T-bill return and the roll return by year since 1971 and also how the GSCI total return index has done relative to the spot index over that time. You can see the T-Bill return has dwindled down to zero over the last few years, consistent with the gradual drop in interest rates since the late 70s and early 80s. You can also see that the general trend in the roll return has turned negative since the late 90s, which as I have said, I think is consistent with the emergence of commodity mutual funds and ETPs.

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In conclusion, I think investors in these products really need to take a hard look at what they are holding and ask themselves if they expect any changes in the market forces currently operating against commodity futures. As you can see, there are multiple factors that can cause the return from commodity futures to deviate significantly from what is occurring in the spot market. Understanding what drives these deviations and adjusting for them should be a part of the analysis of any investor's commodity holdings.

Source: Understanding Futures-Based Commodity Fund Returns