By Lara Crigger
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.
Crigger: In your paper, you claim that some of the methods providers have come up with to "overcome" contango in fact bias investors toward negative returns. Why is that?
Rahal: You have some indexes out there that are long/short, which are dependent on market content. You have some indexes that will change their duration; that will measure the difference in price between the current holdings and different parts of the curve, and base their rolls upon a given rule.
But I really think any index based on this methodology—it's almost like another form of active management. There's no assurance that whatever characteristic or attribute you're trading on will continue. In fact, they're almost saying that these markets have some predictability about them, that they're trading on superior knowledge, or their ability to predict. That, I think, is just bound to fail.
I'm not saying I'm against active management. But you have to be careful. There may be active managers that can outperform over time, but I don't really know too many.
Crigger: So when investors are looking at commodities indexes, what criteria should they be looking for?
Rahal: First thing: Reduce your turnover. The less you touch the market, the better it is. It's like how you might buy the S&P 500 or Dow Jones stocks and then hold them for 50 years. Yes, the S&P 500 and Dow Jones do change occasionally, but generally speaking, that, to me, is the spirit of how to approach a commodity index. I prefer indexes that are invariant.
Also, if you don't continually change an index, then it can become a benchmarking vehicle, and you're able to compare period to period. If I show you a portfolio that changes every year, I can't really compare the return of this year to the return of last year. So you would want to have your benchmark be an invariant type of index, without lots of turnover.
Even within the same commodities, the less we roll, the less turnover we have, the better. You can't buy a 10-year corn contract, and even if you could, it wouldn't have the liquidity to be a responsible investment. So any decision we make in the commodities space has to be in light of liquidity and the availability of the market. Still, less turnover is better.
The other thing is, commodities are an artifact of futures, so they appear to have more volatility in the front month than in the back. Volatility is not the friend of a long-term index-type investor. So an index that avoids the front month is ideal. Of course, here we have the DJ-UBS and the S&P GSCI created to be in the front month!
Crigger: Sure, and it's a lot more than just those two indexes as well.
Rahal: Exactly. Never own the front month. Wherever speculators want to be, I don't want to be. I never want to be in the front.
Another thing: Commodities have higher or lower volatility by season. They have seasonality terms. Long-term holders who want to avoid unnecessary volatility should never own high seasons. I want to hold back-month and shoulder months. That's so counterintuitive, but that kind of position, in my experience, will outperform the portfolio that's continually "where the action is." Where the action is, that's where I don't want to be.