Many commodity funds have been losing investors money this year because of an often overlooked issue: the roll yield. Simon Wilson explains
Why do people invest in commodities?
Until relatively recently, hardly any retail investors took the plunge into commodities. Raw materials such as metals, energy and foodstuffs were seen as obscure, illiquid, and offering poorer returns than equities or bonds. However, over the past few years, commodities have surged in popularity among retail investors for very sound reasons. First, because they have offered high returns, boosted by a strong long-term growth story, namely Chinese and Indian demand. Over the past five years, they have returned a more-than-healthy annualised return of 13%. And over the last ten years, the figure is a still-solid 7.5%. Second, commodities have grown in popularity because returns have tended to be very weakly (and sometimes negatively) correlated with other asset classes, such as stocks. They are therefore seen as a useful way of diversifying a portfolio.
Are they still a good way to diversify?
Not if they offer terrible returns – and this year, returns to investors have been dire. Investors in a typical commodity futures index have seen their investment shrink by around 12%. That might not sound too horrific – it’s the sort of volatility that any investor in equities should expect from year-to-year. But the worry among some analysts is that the downturn in commodities is not due to the lack of willing investors, but (paradoxically) due in part to the high number of new speculative investors. When commodity investment was a niche market, it was possible to make excellent returns, but now that everyone wants in, it’s spoiling the party.
Surely more investors is good news?
Not always. In recent months, several economics consultancies and investment banks have issued papers warning that the arrival of the private investor, combined with buoyant demand for the commodities themselves, has led to significant distortions in prices. To understand why, we need to look at the mechanics of commodity investment. It is obviously impractical for ordinary investors to buy and store physical commodities.
An alternative might be to invest in a portfolio of commodity-related stocks. This route, however, does not offer the diversification benefits that investors are looking for. So typically, investors gain exposure to commodities through the futures market, by buying an exchange traded futures index – ie, a basket of futures contracts in many different commodities.
Sounds sensible – what’s the problem?
The key issue is the disappearance of ‘backwardation’ in the futures market and its replacement by the equally intriguing condition known as ‘contango’. Backwardation is a downward slope in futures price, as in the chart on the left, below. Economic theory tells us that backwardation is the normal state for many commodities markets, since their purpose is to enable producers to hedge by selling their future output in advance. Consequently, there will be more sellers than buyers for longer-dated contracts and thus lower prices. But with the flood of investors entering the futures market, the “previous shortage of natural long investors has been removed”, says economist Simon Hayley of Capital Economics. “Thus it should come as no surprise that the previous backwardation has now disappeared” in favour of an upward sloping curve – ‘contango’.
Why does this matter so much?
Because much of the historical return from commodities has come not from rising ‘spot’ prices – until recently, real prices had fallen for many years (see the chart on the right, below) – but from the effects of backwardation. This is because futures contracts only have limited lives; when an old contract expires, you need to reinvest in a new one. This rolling-over of contracts produces something called the ‘roll yield’. So long as the market is in backwardation, every time you roll over your contract into a new, slightly cheaper one, you stand to make a small gain, accruing a substantial cumulative return. But when the market is in contango, the roll yield turns negative and you make a loss.
What should investors do?
They should carefully examine the way in which they invest in commodities. While MoneyWeek believes that commodities are in a long-term bull market, there may well be down cycles within that market. And while buying and holding an asset for the long term is usually better than trying to time the market, roll yield means that this may not be the case when investing in commodity indices. At times when a commodity is in contango and the spot price is not rising strongly enough to offset the roll-yield loss, it may be best to exit the position until the market is more favourable. Some commodity index and fund providers – including Deutsche Bank and Barclays – are now selling products that try to reduce the roll yield problem, but it remains to be seen whether the savings are worth the higher fees.