Commodities investing is not as easy as you might think
Investing in commodities has become popular among investors in the last decade, in part due to the ease of investing in them through ETFs. However, a lot of investors have been disappointed with the returns they made. In this article we explain why.
When commodity prices are low, it may look like an obvious time to invest, but can in fact result in returns significantly below expectations as investing in commodity exchange traded funds (ETFs) is not the same as purchasing equity or fixed income ETFs.
Equity and fixed income ETFs give you proportional ownership of a small amount of the equity or debt securities making up that index. Commodity indices, on the other hand, give you exposure to some physical commodities, such as gold and silver, which are easy to store, but much of the allocation will be to commodity futures.
This is because physically owning soft commodities, such as non-precious metals, can require huge storage facilities (eg natural gas), or a timely buyer (eg corn and live cattle) which makes taking delivery of the underlying product a potentially unwelcome outcome.
Commodity ETFs: rolling futures
Instead of the ETF owning physical commodities, the index provider behind the allocations will have rules that are similar in some aspect to this: buy a commodity future with three months until delivery, sell it once it has a month to expiry, and then reinvest the proceeds in the next three-month future.
This is known as rolling a contract, and the returns the investor will get are subject to the shape of the futures curve. An upward sloping curve means investors will continually sell the near-dated future, and buy into one that is more expensive. In the industry this is known as ‘contango’ or a ‘negative roll yield.’ Conversely, when futures curves slope downwards, where the market expects prices to fall, an investor can sell a more expensive contract to buy into a cheaper one, which is known as a ‘positive roll yield’ or ‘backwardation.’
Chart 1: backwardation and contango
Source: IG, May 2017
Historically, commodity indices used to be in backwardation, as commodity producers would sell forward some of their production to lock prices to reduce their business risk. Institutional investors saw this as a source of returns and a way to diversify their portfolios, and commodity investing soon became a feature of most multi-asset portfolios as a way to hedge against inflation.
Over time, as more investors, who didn’t want the final product, allocated money to commodities as an inflation hedge, the return profile of the asset class started to evolve. Commodity producers could begin to lock in higher prices by selling their production forward, a win-win situation from their perspective as it allows reducing business risk and doing so at higher prices.
As is evident in the chart below, contango in commodity futures has been a killer of long-term returns for commodity buy-and-hold investors. Taking 20 years of returns from the Bloomberg Commodity Index, the spot price index is up 240% to the end of April 2017. However, the return that investors in the investible Total Return Index would have made is just 27.5%, an annual underperformance of 5.1%.
In fact, the returns from investing in the index would have been worse — a loss of 16% over 20 years (before fees and transaction costs). This is because when purchasing a commodity future, the investor has to partially pay for their exposure through posting initial margin to the exchange, and the Bloomberg index makes the assumption that the rest of the investor’s cash is invested in three-month US T-Bills. Over 20 years the return from the reinvested T-Bills would have returned 2% a year, offsetting losses in the underlying commodity markets.
Chart 2: Commodity Index returns
Source: IG and Bloomberg, May 2017
Investing in oil ETFs
In chart 3 we can see how contango hurt the returns of a London-listed oil ETF. The price of West Texas Intermediary oil fell from over $100 a barrel in 2014 to $35 by the end of 2015. Many investors wanted to get exposure to the oil price through an ETF, as they thought it was oversold. The ETF performed exactly as expected, but when the oil price finally bottomed in February 2016, the oil market went sharply into contango. Over the year this resulted in a gain of 45% for the WTI oil spot price, but just 8% for the ETF.
Chart 3: oil ETF investing in futures vs. Oil spot price
Source: IG and Bloomberg, May 2017
You can see in chart 4, how the WTI futures curve was positioned at the beginning of 2016. The 12-month future was 18% higher than spot price, and the regular rolling of shorter term contracts over the year – each time at a higher price – proved to be very costly.
Chart 4: WTI oil futures curve 31 December 2015
Source: Bloomberg, May 2017
What other alternatives do investors have?
Long-term investors in precious metals are unaffected by commodity futures, as physical gold and silver can be held on behalf of the ETF provider. Investors in non-precious metal commodity ETFs need to be more careful, and may want to consider purchasing sector ETFs to get exposure to oil and miners, or to allocate directly to individual producers that they feel will benefit most from rising prices.
While many commodities are currently in contango, others, such as cotton, are not. Therefore commodity ETF investors can benefit from the shape of the futures curve, but before investing in any of them it is advisable to do your research.