Commodity indices: ‘rollover’ practice hits investors

Since commodities became a nascent asset class in the early 2000s, most institutional money, particularly pension funds, have gained exposure to it through long-only, passive indices, including the S&P GSCI, DJ-UBS and the Reuters-Jefferies CRB.

The investment case for indices was reinforced by Gary Gorton and K. Geert Rouwenhorst, of The Wharton School at the University of Pennsylvania and the Yale School of Management, who in their “Facts and Fantasies about Commodity Futures” paper studied how investing in a commodity index will affect investors’ portfolios.

They constructed a commodity index and studied the returns from 1959 to 2004, concluding that while the risk premium of the commodities index was essentially the same as equities, commodity futures returns were negatively correlated with equity and bond returns.

“The negative correlation between commodity futures and the other asset classes is due, in significant part, to different behaviour over the business cycle. In addition, commodity futures are positively correlated with inflation,” they added.

Since this discovery, pension funds and other investors had been attracted to commodities in the hope that returns will differ from equities and bonds and be strong in case of inflation.

But it emerged later that, in spite of the advantage of diversification, the indices have a problem. They are, in essence, baskets of raw materials – usually with a heavy weight towards energy and oil in particular – and the investors who track them invest in nearby futures and roll their positions to the following contract ahead of the expiry.

The mechanics of selling the expiring contract and buying the nearby future – known as “rollover” in the industry jargon – is behind the main problem of the indices and the reason why many investors are questioning the wisdom of using them. Because the investors sell one future and buy the following one, the shape of the futures curve is crucial to the profitability of commodities indices. In addition to the spot return, commodity index investors obtain a separate return – the roll yield – as they roll trades over each month, just before the futures contract expires. That return is positive when futures prices are lower than the prevailing front-month price – a backwardated market – and negative when futures prices are higher – or in contango.

For most of the early 2000s, when commodity indices were the star vehicle to gain access to commodities, the markets were in backwardation, offering strong “yield” returns to investors on top of rising spot prices. But episodes of contango since 2006 have eroded gains, in some cases more than offsetting the rise in spot prices, or added to losses when spot prices were declining.

The problem was so great early this year that Goldman Sachs, which created the Goldman Sachs Commodities Index (GSCI) – rebranded after S&P acquired it in 2007 – told investors to exercise caution on indices.

“While we remain long-term bullish on direct commodity investments, it is this large cost of holding the position [rolling] that drives our underweight recommendation on direct commodity investments,” Goldman Sachs told investors in February.

Since January 2005, the S&P GSCI spot index – measuring just the appreciation of the commodities – has risen a massive 60 per cent on the back of China’s voracious appetite for raw materials. But when taking into account the roll yield, the total return is a loss of about 15 per cent during the period due to the contango, according to Reuters data.

The picture is similar this year, with the S&P GSCI up almost 45 per cent on spot terms, but only about 10 per cent on total returns terms.

Although indices are still the preferred vehicle to gain access to commodities, the contango problem has forced banks to create new benchmarks, while some investors have moved to active strategies.

In spite of all the problems, bankers believe commodities indices – vanilla ones affected by the contango or the more exotic new varieties built to mitigate the problem – will continue to be popular as the easy way to gain access to the commodities asset class.