Marc Gerstein

Commodity Index Funds: The Good, The Bad and The Ugly

Right... backwardation is associated with positive roll yield 9a god thing) and contango is the reverse.

Neither has anything to do with whether commodities are good or bad as an investment. These are just facts of life in the commodity world and need to be understood in order to follow what's going on.

For example, I might be bullish notwithstanding contango if I were to expect the spot price to rise enough to make for worthwhile investment performance even after applying a contango-based haircut. Conversely, if I expect prices to plunge, backwardation might not be enough to cause me to get in. Less extreme prospects either way might make roll yield a more prominent aprt of the investment case.

The bottom line here is that there is a lot to commodities and one can never make a pat pronouncement that they must or must not be owned, or even that they're speculative (sometimes they are, sometimes they aren't, and often they are for some commodities but not others). Oversimplification, superficial assessment, etc.... that is what causes investor pain. That's so with stocks. that's so with fixed income. That's so with options. That's so with commodities, etc.


On May 11 02:05 PM Living4Dividends wrote:

> From my very limited knowledge of commodities
> the investor gains positive roll returns (makes money) during backwardation
>
> I would assume that the investor does not get positive roll returns
> during cotango.
>
> My question to Marc Gerstein is: how does that make commodities
> a bad investment?

Commodity Index Funds: The Good, The Bad and The Ugly

Contango refers to a situation wherein a futures contract trades above fair value, which is computed based on the spot price,interest rates, and time to expiration. At expiration, the contract's value must necessarily equal the spot price.

Because commodities are futures contracts with expiration dates, no investor can buy and hold. The best they can do is rollover into a new contract as expiration approaches. when contango is present,they'll pay a premium to do this, and that can really cut into the returns one might expect to see based solely on examination of spot price trends. (Backwardation is the reverse, where the futures trade at a discount to fair value and rollover creates a bit of a windfall. But in rising markets, contango is more likely.)

That said, i stilll would not necessarily describe commodity ETFs as speculative (I'm not a fan of the ETN). Whether they are or not is as we see for stocks; it all depends on what's happening in the market. Sometimes, commodities attract huge amounts of hot money investing and reach prices that are, indeed, speculative. Other times, when the hot money goes elsewhere, commodities can look quite conservative. It's just like stocks. Instead of relying on a pat formula, one must look at what's going on.

My personal opinion is that right now, commodities look fairly reasonable. The next significant move in global demand for tangible goods is more likely than not to be upward, supply seems unlikely to keep pace, and the ot money that was all over commodities a few years ago seems to now be sitting in the spectator section. As to contango, look at how an ETF handles the last commodity rally. It'll provide a clue as to how effective their rollover strategy (how close to expiration they go before doing the rollover and how far out they go with the new contracts) has been. Chances are it won;t change since these rollover protocols are locked in via prospectus; ETFs don't have fund managers playing hunches. But that's my opinion. If I'm wrong, it will probably be because I'm too optimistic about economic prospects going forward.

As to blanket statements that one should have 5% in commodities, I reject all statements that suggest X% in such-and-such asset class. In all case, the appropriate % depends on the risk-return inclinations of each investor, and, of course, market conditions.

Commodities aren't magic. It's just another investment and like others, it should be subjected to basic fundamental analysis (and technical for those into that) and favored when the analysis says "yes" and avoided when the analysis uncovers too many red flags. (By the way, I think the importance,nowadays of tangible goods production is why we've seen commodities become much more correlated with stocks.)

Commodity Index Funds: The Good, The Bad and The Ugly

There are some valid points here, particularly regarding counterparty ETN risk and the increase in correlation between commodities and other asset classes. But in other ways the views here seem a bit dated.

Commodities is a fancy word for "stuff" and as such, prices will rise or fall in response to supply and demand for "stuff." The recent sure related to huge new sources of demand as economies in places like India and China started to seriously strut. The bust came in response to corrections there, as well as in some excesses here (i.e. investment demand that ran too far too fast). At this point, we really need to be seeing commodities more as a play on global economic growth. As to the inflation hedge, we;ll need to wait a while, let a full business cycle get underway, and see what happens; whether commodities still have appeal on this ground.

Interestingly, in making your harsh judgment against commodities you missed the main point that could have been raised to support your case; the impact of contango and negative roll yield, and how they imact ETF-ETNs (and ofcourse, you;d have to cover the flip side; backwardation and positive roll yield). That's a very odd omission.