By Samuel Lee
Negative real interest rates, coordinated money-printing by
Bernanke and his international counterparts, rising emerging
markets--little wonder that commodity fund assets have tripled
since the commodity-price peak in mid-2008. It helps that back
tests show long-only, futures-based commodity indexes had
equitylike returns and little correlation to the markets, the holy
grail of portfolio diversification. The rush to carve out a static
allocation to commodity indexes such as the S&P GSCI or the
DJ-UBS Commodity Index is, in our view, suboptimal behavior.
Without understanding the drivers of commodity futures returns and
capitalizing upon them, investors will fail to capture the biggest
sources of commodity futures profits.
Not Always Positive Expected Return
A long-only position in commodity futures is not always expected to
provide an excess return above the risk-free rate, as is the case
with stocks and bonds (the market will always try to price stocks
and bonds such that their expected returns are above that of
cash--why else would anyone invest in them?). The futures market
can be considered an insurance market, where hedgers and
speculators trade risks. There is no expectation of positive
returns in aggregate--someone's gain is exactly offset by someone
else's loss, minus frictional costs. Hedgers pay an insurance
premium to speculators. They willingly bear a negative expected
return in order to shed themselves of risk.
In John Maynard Keynes' theory of normal backwardation,
producers are the natural hedgers. They compensate the
insurers--the speculators--with a positive roll yield, the profit
from rolling over a longer-dated futures contract to a
shorter-dated one. This occurs when more-distant futures trade at
lower prices than the spot price, a condition known as
backwardation. In this framework, a static long-only futures
position should be compensated with positive expected returns.
However, the historical data is not very supportive of this
story. The average roll yield for 12 major GSCI commodity futures
for the period January 1983 to January-end 2012 is negative. In
other words, contango, the state opposite of backwardation, was the
greater force. Something else is going on.
A better approach accounts for the fact that sometimes long-only
futures exposure becomes a negative return proposition. Two
possibly complementary approaches are the hedging pressure
hypothesis and the theory of storage. The hedging pressure story is
more general than Keynes' theory of normal backwardation: It holds
that when producers demand more hedging, the futures term structure
goes into backwardation, rewarding long positions; when consumers
demand more hedging, the term structure goes into contango,
rewarding short positions. The theory of storage holds that
backwardation and contango can be explained largely by physical
inventory levels; when inventory is low, markets become
backwardated; when it's high, they become contangoed.
Both theories hold that the rewards for bearing risk accrue to
the side, long or short, that offers some kind of insurance. In
other words, long-only positions will not always possess positive
expected returns. A static long-only commodity allocation over the
course of a full market cycle will switch between insurance
provision (positive expected returns) and insurance consumption
(negative expected returns). A static, long-only investor is partly
betting that the long side of the market remains mostly in
insurance-provision mode over the course of his investment.
Falling Expected Returns
There are good reasons to think that the expected returns of
commodity futures aren't terribly high. Claude Erb and Campbell
Harvey propose that the returns of long-only portfolio of commodity
futures can be decomposed into four parts: the risk-free rate, the
spot-price return, the roll yield, and the diversification return.
We'll treat each component in turn.
1) Risk-free rate. The risk-free rate is low, so fully
collateralized futures investors won't earn much of a cash return.
Historically, this has made up about half the returns of the GSCI,
the most popular commodity index.
2) Spot-price return. Markets already anticipate high commodity
demand, so spot prices are high. Historically, markets have tended
to overprice growth; there's little reason to think this is
different. However, if your estimate of prospective spot-price
returns is higher than the market's, a long-only commodity
allocation can make sense despite other factors detracting from
3) Roll yield. For the past five years, coinciding with surging
commodity index assets, the term structure of most commodity
futures has mostly been in contango, meaning negative roll yields.
Over the long sweep of time, roll yield has swamped out spot-price
4) Diversification return. Historically, commodities have had
low correlation with each other and high volatilities. By simply
regularly rebalancing, many indexes earned a positive
"diversification return," which accounts for a big part of the
excess returns commodity indexes earned. Ke Tang and Wei Xiong
documented surging correlations between individual commodity
futures, especially ones in the S&P GSCI and the DJ-UBS
Commodity Index. The historical diversification return for the big
indexes has been around 3%. If correlations remain high, that
return could halve.
A plausible projection using the building-block approach can go
Expected long-only futures return = Risk-free rate +
(Spot-price return + Roll yield) + Diversification return = 0% +
0% + 2% = 2%
There's another reason to expect lower expected returns: The
pool of insurance buyers has been shrinking relative to the pool of
providers. Hedge funds, pensions, and individual investors have all
scrambled to add long commodity futures to their portfolios.
Proportionately, hedgers have shrunk. In fact, long-only investors
may have transformed into insurance demanders, possibly accepting
low or negative expected returns for inflation protection.
Given today's lowered expected-return outlook and the dynamic
nature of the rewards that commodities exposure offers, why would
an investor own a static, long-only allocation to commodities?
Unlike stocks and bonds, there is no theoretical reason to expect
positive returns at all times. The static, long-only commodities
investor is riding the hope that the markets have not fully
impounded future spot-price appreciation into current prices.
There's even another reason to question the use of conventional
long-only commodity index products: The biggest ones suffer
front-running and market-impact costs. Yiqun Mou of Columbia
University estimated that the GSCI forewent 3.6% annualized from
January 2000 to March 2010 owing to these costs. Investors pay
dearly for tracking the big indexes.
More Rational Commodities Investing
Dynamic commodities exposures have a better rationale for positive
excess expected returns, particularly ones that take advantage of
momentum and backwardation. (Paul Kaplan provides a cogent summary
of why this is the case.)
Momentum is especially powerful. In a 2008 study typical of the
genre, Ana-Maria Fuertes, Joelle Miffre, and Georgios Rallis found
that momentum-based strategies were exceptionally profitable. For
instance, a strategy that goes long the highest-returning 20% of
commodities over the past 12 months and short the lowest-returning
20%, rebalanced and reconstituted monthly, earned 12.6% annualized
from January 1980 to January-end 2007, well above the
equal-weighted benchmark's 3.4% annualized return.
They find similar results for backwardation strategies. A simple
strategy that each month owns the top 20% in backwardated contracts
and shorts the 20% most-contangoed contracts, reconstituted and
rebalanced monthly, earned 11.7% annualized.
Some researchers, such as Gary Gorton, Fumio Hayashi, and K.
Geert Rouwenhorst argue that momentum- and backwardation-based
strategies exploit information about inventory levels, suggesting
that such strategies will continue to have positive excess
Two ETF strategies offer the kind of dynamic exposure we like:
PowerShares DB Commodity Index Tracking (
) each month targets futures contracts that offer the highest
implied roll yield; United States Commodity Index (
) each month picks the seven most-backwardated contracts and then
the seven highest-returning contracts, equal-weighting them.
By intelligently moving away from contangoed, low-returning
futures contracts, the ETFs offer a good alternative to static
exposures. While they may not be able to short contracts,
Fuertes-Miffre-Rallis' research suggests that most of the profits
to momentum and backwardation strategies come from the long
But even they don't guarantee great (or even positive) returns.
Hedge funds are likely squeezing out much of the profits to such
strategies. But the alternative--static, conventional commodity
indexes--is even more unappealing.
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
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