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    • Sat Oct 20th 19:14 PM | Rating: 0 0
      Commented on:
      Commodities ETF Returns: It's All About the 'Roll Yield'
      Morningstars white paper also has contradictions and over-simplifications too... States "Someone is short a commodity futures contract for every long one." This implies a symmetric market, and therefore there is no positive expected positive return. Then it turns around and argues the case of capturing for free the storage market risk premia on pure speculative basis and not on a relative trade basis (eg, long spot/short futures, or some combination calendar spread). Note: the true definition of backwardation / contango relation has to do with relative pricing of a futures month contract to its expected/delivery spot price! It is technically not the relation between different month future contracts.

      The "simplified" theory is that upward sloping futures prices represent contango markets and downward sloping futures prices represent backwardated markets. This may be an indication of contango or backwardated markets, but in "classic" theory, the relationship is between a futures contract and its expected future spot value which is an unknown. Therefore, it is theoretically possible to have upward sloping futures prices implying contango, but with respect to a specific futures month contract and its expected futures spot price that relation could be actually backwardated. Situation can also occur vice versa. BTW, theoretical arbitrage relation is that the expected futures spot price is equal to spot price + carrying costs - convenience yield.

      Here is another way to look at it... one way to make money is by being short gamma, selling options and letting theta to the heavy lifting. The strike price is known, and one has a way to guage the risk of the trade and know whether or not the trade is working based on changes in the underlying prices relative to the hard-coded strike. This whole roll yield concept is trying to sell a "simplified" (not classic) version of the theory of backwardation and contango by implying a comparison to naked short option trading, and then claiming that you can pick up the carry for free on a spec basis (which the academics in fact disagree if possible or not based on empirical research). The problem is that the expected futures spot price is not locked in, its a moving target! Worse, its an unknown that is can only be theoretically approximated by speculators, and only truly known by a specific hedger and its particular business situation (ie, their specific carrying costs).

      Also, in actual trading application, the so-called roll yield is reduced if not destroyed by the very institutions that are trying to capture it. Think about it... if the market is backwardated in accordance with the simplified theory, then the forward futures contract should be higher than the further-out futures contract. The roll entails selling the forward futures contract at higher price (putting downside pressure on that contract) and buying the further-out futures contract (putting upside pressure on that contract). Now imagine if subsequently the market for whatever reason goes down 10 points... are you any further ahead because of the roll yield? Maybe you think you are because you theoretically "bought" at lower price, but remember, the classic theory is the relation of that futures contract to its expected future spot price, and there may have been a different set of fundamental dynamics underlying that relation that created the illusion of a calendar roll yield that truly wasn't there.Enter your comment here
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    • Sat Oct 20th 19:09 PM | Rating: 0 0
      Commented on:
      A Look at Backwardation and Contago in Commodity ETFs
      Morningstars white paper also has contradictions and over-simplifications too... States "Someone is short a commodity futures contract for every long one." This implies a symmetric market, and therefore there is no positive expected positive return. Then it turns around and argues the case of capturing for free the storage market risk premia on pure speculative basis and not on a relative trade basis (eg, long spot/short futures, or some combination calendar spread). Note: the true definition of backwardation / contango relation has to do with relative pricing of a futures month contract to its expected/delivery spot price! It is technically not the relation between different month future contracts.

      The "simplified" theory is that upward sloping futures prices represent contango markets and downward sloping futures prices represent backwardated markets. This may be an indication of contango or backwardated markets, but in "classic" theory, the relationship is between a futures contract and its expected future spot value which is an unknown. Therefore, it is theoretically possible to have upward sloping futures prices implying contango, but with respect to a specific futures month contract and its expected futures spot price that relation could be actually backwardated. Situation can also occur vice versa. BTW, theoretical arbitrage relation is that the expected futures spot price is equal to spot price + carrying costs - convenience yield.

      Here is another way to look at it... one way to make money is by being short gamma, selling options and letting theta to the heavy lifting. The strike price is known, and one has a way to guage the risk of the trade and know whether or not the trade is working based on changes in the underlying prices relative to the hard-coded strike. This whole roll yield concept is trying to sell a "simplified" (not classic) version of the theory of backwardation and contango by implying a comparison to naked short option trading, and then claiming that you can pick up the carry for free on a spec basis (which the academics in fact disagree if possible or not based on empirical research). The problem is that the expected futures spot price is not locked in, its a moving target! Worse, its an unknown that is can only be theoretically approximated by speculators, and only truly known by a specific hedger and its particular business situation (ie, their specific carrying costs).

      Also, in actual trading application, the so-called roll yield is reduced if not destroyed by the very institutions that are trying to capture it. Think about it... if the market is backwardated in accordance with the simplified theory, then the forward futures contract should be higher than the further-out futures contract. The roll entails selling the forward futures contract at higher price (putting downside pressure on that contract) and buying the further-out futures contract (putting upside pressure on that contract). Now imagine if subsequently the market for whatever reason goes down 10 points... are you any further ahead because of the roll yield? Maybe you think you are because you theoretically "bought" at lower price, but remember, the classic theory is the relation of that futures contract to its expected future spot price, and there may have been a different set of fundamental dynamics underlying that relation that created the illusion of a calendar roll yield that truly wasn't there.
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    • Thu Oct 18th 00:44 AM | Rating: 0 0
      Commented on:
      Commodities ETF Returns: It's All About the 'Roll Yield'
      Yield roll is a myth perpetuated by a misunderstanding of backwardation and contango concepts... If these annualized roll returns are correct, then why not just arbitrage the higher "current month contract" against the lower "future month contract" when backwardated and vice versa when market is contango? That is the basis for many CTA trading programs: calendar spreads. Obviously, however, speculators (unless they want to hold the cash commodity) can't hold the spread for the full period because the current month contract converts to spot before the future month contract. That's the point... Backwardation is the arb between current spot price or future contract price versus expected future spot price (which is an unknown!). Theory states that exepcted future spot = current spot plus carrying costs which includes storage costs plus convenience yield... If an arbitrage opportunity really exists (ie, market is backwardated) then you should be able to sell futures and buy spot and hold in storage until delivery and come out ahead... Reason why preference is backwardation is becuase its hard to borrow and short cash commodities... that's part of the logic/reasoning underlying Keynes, Hicks theory of congenital weakness... The theories have become mythologized, with simplified interpretations perpetuated by institutional firms selling index products. However, the academics' aggregate body of work disagrees on whether or not there is in fact positive systematic risk (ie, risk premia)... Allen, Cruickshank, Morkel-Kingsbury and Souness (1999) study states "there is no consistent evidence about the existence of normal backwardation despite a long tradition of research which dates back to Keynes (1930), Hardy (1940), Working (1948, 1949), Houthakker (1957), Telser (1958, 1967), Cootner (1960, 1967), Rockwell (1967) and Dusak (1973)... Dated research? Then try Erb and Harvey (2006) who posit: "for investors considering a long-only investment in commodity futures: how can a commodity futures portfolio have 'equity-like' returns when the average returns of the portfolio's constituents have been close to zero?" As noted by Ebrahim and Rahman (2004), who echo Bray (1992), Sheffrin (1996) as well as Malliaris and Stein (1999), "this discrepancy between theoretical assertions and empirical behavior is a puzzle. Is there something missing in the theory?" I think there is... its called reflexivity. spamfighter01@earthlin...
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    • Wed Oct 17th 20:20 PM | Rating: 0 0
      Commented on:
      A Look At The Next Generation of Commodity Indexes
      This bears further study, but initial thought is that Morningstar is contradicting itself. If the commodity futures market is symmetric, then logically roll yield is an illusion at worst; at best roll yield opportunities can only be realized through fundamental analysis/active management, not passive management... passive management will result in long-term symmetric outcome = 0... My thesis is that roll yield (ie, backwardation, contango) exists, but only in narrowly define circumstances tied directly to specific bona fide hedger within specific timefame/context... That is, roll yield model = arb model which is circular reference! Also, if speculators are being paid risk premia, that premia is being spread too thinly and returns are then result of inherent leverage in futures market (10x based on maring/equity) (See Spurgin 2000)... beyond that, claims of passive investment indices capturing roll yield risk premia is questionable myth of industry... BTW, annualized roll yield chart Exhibit 2 is from Erb and Harvey (2006) study... this study is contradicted by certain prior studies which concluded systematic risk = 0... all are modeled on regression analysis, therefore backward looking, curve-fitted, and optimized... CFTC requires hypothetical disclosure... Is morningstar disclosing that roll yield chart as hypothetical? Perhaps they should be! Academic research dating back to Dusak (1973) is inconsistent as to whether risk premia is available, either backwardated or contango... Beware of marketing masquerading as studies... again, the studies are inconsistent and may be based on false assumptions... Backwardation/contango model is circular reference! Futures markets are behavioral... Passive strategy = systematic trend-following CTA... Also, morningstar is copying similar passive strategy of MLM Index which has been around since 1988. Understand that alpha decisions are which sector to weight at any particular time over what time period... their 10% cap on weightings skews any logical economic analysis... Finally, note that passive strategy is backward looking, not forward looking... since methodology is made public... will be faded by speculators/arbitrageu... and morningstars' assumed roll yields will be arbed away... spamfighter01@earthlin...
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