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Why Conventional Commodity Indexes Will Likely Disappoint

A look at the true drivers of commodity futures returns shows that popular indexes like the GSCI are lacking.

Samuel Lee, 02/28/2012

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.

Samuel Lee is an ETF Analyst with Morningstar.
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