Commodities ETF Returns: It's All About the 'Roll Yield'

Includes: DBC, DJP, GSG, GSP
by: IndexUniverse

For a long time now, I've been writing about the importance of contango and backwardation in the commodities market. It's something I think investors still don't understand, and it's as fundamental to commodities as earnings and dividends are to stocks. (I've included definitions at the bottom of this post.)

I made a bit of a to-do about the commodities market in July when the oil market switched from contango to backwardation. I think the word I used was "Rejoice!" Finally, I said, it was safe for commodity index investors to go back in the water.

My rejoicing missed a bit of nuance. A recent article on compared the current levels of contango/backwardation for 10 core commodities. What's interesting is that while crude oil is backwardated, all the other commodities are in contango ... and sometimes vicious contango. Aluminum, Heating Oil, Corn, Natural Gas ... all are so strongly contango-ed they would make savvy investors weep.

(Note: the roll yields on Natural Gas, Heating Oil and Corn are exacerbated by seasonal factors. Nonetheless, they remain very large on the "next contract" basis.)

These differences are important for index investors to understand because different commodity indexes hold hugely different positions in commodities.

There are three major commodity indexes tracked by ETFs or ETNs: the GSCI (tracked by GSG and GSP), the DBC (tracked by DBC) and the DJ-AIG (tracked by DJP). Those three indexes hold wildly different positions in energy components: GSCI at 71%, DBC at 55% and DJ-AIG at 33%. And even within energy, the positions vary: GSCI is 52% crude, 7% natural gas and 12% "other"; DBC is 35% crude oil and 20% heating oil; and the DJ-AIG is 12.5% crude, 12.5 natural gas and 8% "other."

For investors in GSG, DBC or DJP, these differences are critical. GSG has the most exposure to backwardation, DBC is in the middle and DJP is currently exposed to contango.

You can guess where I'm going here: That's right, since the crude oil market switched to contango in July, GSG has been the best-performing ETF by far, followed by DBC and then by DJP. And not just by a little: GSG has gained nearly 10% on DJP over the past four months ... an extra 30% annualized return.

The chart below shows the year-to-date returns, with GSG in blue, DBC in red and DJP in green.

I've said before that commodities are a special case, where—more so than with stocks—investors must understand the components of individual indexes, and must understand issues like contango and backwardation. The will become even more important as "smart" commodity indexes like the one underlying the GS Connect S&P GSCI Enhanced Commodity Total Return Strategy Index ETN (NYSEARCA:GSC) gain traction.

As the chart shows, choosing the right index can make all the difference. defines backwardation as "a market condition in which a futures price is lower in the distant delivery months than in the near delivery months." Contango is the opposite situation.

When the market is in backwardation, a futures index that rolls from the current contract to the next month's contract will realize a benefit — they'll sell an expensive contract and buy a cheap one. When the market is in contango, they'll suffer a loss. This return — called the "roll yield" — is the single most important factor in commodities returns. It is far more important in most cases than changes in the underlying commodity prices.

Written by Matthew Hougan