DIY Investor Magazine
/
March 2017
17
‘COMMODITY ETFS DON’T TRACK THE CURRENT PRICE
OF COMMODITIES, INSTEAD THEY RESPOND TO THE
FUTURES PRICE’
Futures are financial contracts that, for example,
commit you to taking delivery of 10,000 lean hogs in
three months time at a set price. This contract provides
exposure to the commodity without fretting about the
noise, smell and ablutions of 10,000 lean hogs.
As delivery day approaches, our ETF manager deftly
sells the contract on to someone who actually wants the
beasts.
Scale that process up across the world’s major
commodities and you have a working knowledge of how
a commodity ETF operates. It’s a continual process of
buying long-dated futures contracts with comfortably
far-off due dates while selling short-dated ones to
ensure you need never worry about where you’re going
to park all those hogs. Through this mechanism a
commodity ETF provides practical exposure to indexes
that track commodity futures.
ROLL RETURNS MATTER
The outcome of all that futures trading is that commodity
ETFs aren’t designed to track spot prices.
Returns are instead a blend of spot price fluctuations,
interest earned on collateral held by the fund, and the
roll return. The roll return is the profit or loss the fund
makes through its regular futures trading i.e. rolling out
of short-term contracts and replacing them with long-
term ones.
The ETF makes a positive roll return when it can buy
long-dated futures in a commodity for less than it sells
its expiring short-dated contracts. This is a market
condition known as backwardation. But the ETF earns
a negative roll yield when it must buy long-term futures
at a higher price than the short-term ones. This is called
contango. Think of backwardation as a tailwind that
boosts your ETF and contango as a headwind that
makes the going harder. These forces can cause the
performance of a commodity ETF to differ markedly
from spot price trends and are a good reason to
choose a broad-basket commodity ETF over a single
commodity ETC.
Individual commodity markets are highly volatile and
will often switch between periods of backwardation
and contango. But as ever, you can protect yourself
from long periods of under-performance in any one
commodity by spreading your bets across a broad
range. You may even pick up a rebalancing bonus as
commodities tend to have low correlations with one
another.
COMMODITY INDEXES
Before you choose a commodity ETF, make sure you
fully understand its index. Commodity indexes are more
diverse than their equity cousins because there’s no
commonly used weighting mechanism like market cap.
Some indexes weigh their components according to
world production e.g. The S&P GSCI Index.
Others will rank commodities according to economic
importance, liquidity and their diversification potential
e.g. The Bloomberg Commodities index.
Most indexes will set a minimum and maximum weight
for commodity categories, otherwise energy tends to
dominate at the expense of all the others.
You can even choose indexes that exclude particular
categories like agriculture or energy.
Some indexes will try to more closely approximate
spot prices by favouring short-dated futures while
others will focus on optimising roll returns by favouring
commodities that exhibit backwardation.
Take your time to understand the various index
methodologies and remember that even strong
commodities advocates generally stick to an allocation
of between 5 and 10% of their portfolio.
In the ETF search you find a range of broad-basket
