The Current Term Structure Hurts Commodity Returns

As Tom Lydon from ETF Trends recently pointed out more investor education on contango and backwardation - the two forms of the term structure of commodity futures markets - is necessary. As an investor in commodities you have the choice between buying the physical commodity or a derivative (e.g. a futures contract) on a commodity to profit from the price appreciation of the commodity.

However, normally investors discard the first choice as they would have to care about warehousing and other costs of carry. Therefore, most investors invest through commodity futures contracts or through exchange traded funds which in turn also normaly hold commodity futures contracts. The return from a collateralized portfolio of commodity futures contracts comes from three main sources:

Total Return = Spot Return + Roll Yield + Collateral Yield

The spot return is simply the price appreciation in the spot price, which is based on immediate delivery, of the commodity. As an investor in futures contracts has to roll contracts he has to deal with contango (longer-dated futures are more expensive than near-month contracts) and backwardation (longer-dated futures are cheaper). If the term structure is in backwardation the roll yield is positive whereas it is negative when the term structure is in contango. The final source of return is the collateral yield which is the return accruing to any margin held against a futures position and which is normally the US T-bill rate.

click to enlarge

A look at a long-term chart of the ratio between the S&P GSCI Total Return Index [SPGSCITR], which inclues all return components of a passive commodity investment as mentioned above, and the S&P GSCI Spot Index [SPGSCI], which tracks only the spot price appreciation of the commodities in the GSCI, reveals that the roll yield is negative since the begining of 2004 as the ratio has peaked in 2004 and is currently in a steep decline.

Last year Spencer Jakab pointed out that unlike prior commodity price booms, this one is seemingly being driven by an influx of capital seeking out passive, or indexed, commodity exposure. He also addressed the possibility that such a dramatic influx of capital could changed the equation in the futures market thereby negating the roll yield as a major source of returns for fully collateralized commodity futures. However, Jim Rogers - one of the strongest commodity bulls in the markets - seems not to be alarmed by the commodity-wide contango situation.

Deutsche Bank offers a broad-based and several sector-based commodity ETFs, which try to maximize the roll yield by a rules-based formula for replacing an expiring futures contract with a new contract. Lets take a look at the DB Gold Fund (DGL), which in contrast to streetTRACKS Gold Shares (GLD) - that creates exposure to Gold by holding physical Gold - holds futures contracts on Gold, reveals that the roll yield optimization seems to work quite well as the ratio between the DB Gold Fund (DGL) and streetTRACKS Gold Shares (GLD) is quite constant over time, notwithstanding Gold is typically one of the commodities which stays most of the time in contango and has normally a negative roll yield.

However, the investor should never forget that the selection of the constitutes, which make up the commodity index, determines the spot return and is at least as important as the optimization of the roll yield. The chart below clearly shows that the underperformance of iShares GSCI Commodity Trust (GSG) against PowerShares DB Commodity Index Fund (DBC) comes from it's overweight in the Energy Sector, as Crude Oil - mostly the biggest position in the Energy Commodity Sector - has been declining over the last eleven months.

To summarize, beside the roll yield, which has been negative for most commodities in the last 3 1/2 years (see the first figure: ratio between S&P GSCI Total Return Index and the S&P GSCI Spot Index), the spot yield, which is exclusively determined by spot price appreciation of the commodities in the index, is of particular importance for the total return of the investment in commodities. Beside PowerShares DB Commodity Index Fund (DBC), which currently is composed of 55% Energy, 22.5% Metals and 22.5% Agriculturals, the investor has the choice between iShares GSCI Commodity Index Trust (GSG or GSP), which holds 69.3% Energy, 12.12% Agricultural, 13.7% Metals and 4.89% Livestock commodities, and iPaths Dow Jones-AIG Commodity Index Fund (DJP), which has the lowest Energy proportion at 34.7% and 28.46% in Agriculturals, 28.29% Metals and 8.54% in Livestock commodities.

Disclosure: the author has a long position in an ETF issued by ABN Amro which tracks the Rogers International Commodity Index.