Commodity indices and exchange-traded products (ETPs) should be regarded as short- to medium-term investments rather than long-term strategies, as a quick glance at performance over the last 10 years shows.
Their value lies in providing simplicity and liquidity for retail investors and institutions such as pension funds, which do not want the complexity of managing futures positions with their daily margin adjustments and rollovers.
They also permit institutions and retail investors forbidden from investing in derivatives to gain exposure indirectly by repackaging derivatives as swap transactions or embedding them in structured notes, which resemble debt or equity securities.
But they are really only suitable for implementing tactical and value-based views about the short-term direction of commodity prices over horizons ranging from intraday trading of a few hours to as much as six to 36 months to exploit the economic and commodity price cycle.
Their usefulness deteriorates over longer horizons as the cost of carrying the position outweighs eventual cyclical or secular price gains. “Buy and hold” strategies tend to lose money over the long term.
EXPOSURE TO THE COST OF CARRY
Investors in equities and bonds usually receive dividends and coupons to compensate for the use of their capital (as well as upside participation in capital gains in the case of stock).
Investors in physical commodities and commodity derivatives receive no such compensation. Instead they pay for the costs of storage and insurance — either of the physical commodity or for the privilege of deferring delivery in the futures market. They also incur an opportunity cost as they forego returns available on other investments.
For much of the post-World War Two period, costs associated with finance and storage were more than offset by a “risk premium” or “convenience yield” — at least for investors in commodity derivatives rather than the actual physical commodities themselves.
Historic returns series show that commodity producers paid a premium to transfer price risk to investors. Investors also seemed to have captured a convenience yield or scarcity premium from consumers for having title to stocks of ready inventories that were often in short supply.
The existence of this risk premium/convenience yield was most famously observed by Geert Rouwenhorst and Gary Gorton in their landmark study on “Facts and Fantasies about Commodity Futures”, published in 2005. Rouwenhorst and Gorton studied returns on a fully collateralized, equal-weighted basket of up to 25 commodity futures between 1959 and 2004.
But since the start of 2005, the premium or convenience yield has evaporated, possibly as a result of the influx of investor money into commodity derivatives, making it a crowded trade.
Like owners of physical raw materials, investors in commodity derivatives are now exposed to the full cost of finance and storage. In some instances, investors in derivatives appear to be paying more than the actual cost of finance and storage (a “super-contango”). In effect they are now paying, rather than receiving, a risk premium/convenience yield to secure the right to retain upside exposure to commodity prices.
SPOT PRICES AND ACTUAL RETURNS
Running costs have weighed more heavily than most investors anticipated, driving a wedge between the performance of spot commodity prices and the actual returns received by investors.
Charts 1-3 illustrate the wedge driven between spot commodity prices and actual returns to investors for the Goldman Sachs Light Energy Index and two of the most popular exchange-traded funds, the U.S. Oil Fund and the U.S. Natural Gas Fund.
While prompt U.S. crude prices have climbed 67 percent since the start of 2009, an investment in USO has lost 3 percent of its value. For natural gas, the divergence has been even wider. Prompt gas prices have fallen 22 percent, but UNG is down 68 percent.
Some commentators have spoken about a “tracking error”. But these products have not been badly run. All commodity indices and ETPs have suffered the same problem to varying degrees. They have performed exactly as advertised in the prospectus. The cost of carry is intrinsic to returns on all physical commodities and to commodity futures in markets carrying substantial surplus inventories.
Some indices and ETPs have limited (though not eliminated) the carry cost by investing in futures further from expiry and/or rolling positions less frequently. But the only way to eliminate it entirely is to invest in an index or ETP with short exposure to commodity price movements, which brings its own risks if spot commodity prices rise.
TIMING IS AS IMPORTANT AS DIRECTION
It should be clear that being right about the directional movement of commodity prices is not sufficient for investors to make a profit. They also need to accurately predict the timing of any movements and the cost of carry for the period between entering and exiting the position.
Over short periods the cost of carry is very small, so a position in a commodity index or ownership of an ETP will behave much like the spot price, and its carry costs can be ignored. But over longer time horizons, the cost of carry becomes significant and may even dominate movements in spot prices.
For example, assume spot oil prices remain roughly flat for four years but then increase 50 percent between the start of 2014 and the end of 2015. In the meantime the cost of carry averages 10 percent per year in 2010-2013, falling to 5 percent a year in each of 2014 and 2015.
An investor establishing a long position in oil futures at the start of 2010 and rolling it forward before exiting the trade at the end of 2015 will have made nothing by the end of the period. This is effectively the situation for investors who have invested in the GSCI and many of its sub-indices. Everything they have made from the gain in spot prices has been given back via the carry cost.
In contrast, an investor who enters our theoretical trade at the start of 2013 will achieve a total return of 30 percent. Timing matters! In fact the best strategy would be to be short of the commodity futures in 2010-2013, to receive rather than pay the cost of carry, before switching to being long as close to the start of 2014 as possible to benefit from the price spike.
BLINDED BY LONG-TERM THINKING
The biggest mistake made by many retail and institutional investors has been to ignore the importance of timing and carrying cost when taking a long-term view on the direction of commodity prices and their usefulness as a hedge against inflation/devaluation or as a tool for portfolio diversification.
It may be true commodity prices will rise in the medium term because of re-emerging supply constraints and/or resurgent inflation. But that does not make a compelling case for investing in commodity derivatives, let alone physical commodities right now.
Pension funds and some retail investors have been blindsided by their own long-term thinking (and perhaps by greater familiarity with equities and bonds, which do not have a cost of carry) and have overlooked the importance of carry costs and getting the precise timing of commodity price movements right.
At the end of a successful year, one wise trader once remarked: Who paid the bills? In the case of commodity markets, in the last five years, it has often been pension funds and retail investors.
Unless they have a view about the timing of future spot price changes, and cost of carry in the meanwhile, investors should stick to using indices and ETPs as an instrument for expressing short-term views on prices.