When it comes to commodity-futures exchange-traded products, consider your investment time horizon.
The past several years have seen the rise of proliferative interest in commodities as an asset class. Given the recent crash and the Fed's policy response, the cascade of long-only investment demand that poured into the space was born of several needs that commodities do a good job of satisfying.
Historically, commodities have shown to provide diversification away from the correlation of traditional asset classes. On that basis, commodities were looked to as an oasis of diversification following the downturn. As the Fed executed extremely loose monetary policy, hoping to prevent a deflationary spiral through the direct injection of capital to the economy, inflationary fears began to surface. The flames of demand were fanned, as commodities were looked to for their inflation-hedging benefits.
In select cases, investors were afforded access to the spot market by physically backed commodity offerings like SPDR Gold Shares
Today, there are a variety of these products with varying strategies, though it wasn't always so. The very first of these products tracked only front-month futures of a single commodity, a strategy that resulted in very poor returns relative to the spot price over the long term. Here we look to explain the phenomenon that caused such poor tracking, and reconcile the undeserved distaste that has led front-month futures-tracking ETPs to be considered "broken" exchange-traded funds.
A Quick Primer on Futures
Commodities-futures contracts are derivative instruments that obligate parties on either side of the trade to the purchase or sale of a fixed quantity of a commodity at a fixed price and on a fixed date, sometime in the future. Because the actual purchase and sale of the commodity occurs in the future, prices are not set at spot. Rather they are based on the expected price of the commodity upon contract expiration.
Expectations of future commodity prices being driven by extraneous factors will naturally cause current futures-contract prices to deviate from spot. Prices of futures contracts can become more expensive at progressively distant expiration dates, known as contango, or less expensive, known as backwardation. Exchange-traded products merely look to deliver the price performance of commodities to their investors, and have no interest in taking physical delivery of the spot commodity.
To avoid physical delivery, held contracts must be sold before expiration. To maintain exposure, however, contracts further from expiration must be purchased. This process of "rolling" a futures position forward will create a negative yield or loss in contangoed markets and a positive yield or gain in backwardated markets.
The First Generation
The first generation of futures-based commodity ETPs merely held the nearest-to-expiration futures contract, rolling into the next nearest contract as expiration became imminent. Some of the more popular products using this strategy, like United States Oil