Buy, Hold & Lose: How a Commodities Roll Undercuts Investors

  • Gap between index returns and spot prices is widest in 5 years
  • Replacing expired futures boosting fund costs as prices rise

Investors in commodity index funds are coming up short in 2016, even after rallies in more than a dozen raw materials, including sugar, gold and soybeans.

While spot prices tracked by the Bloomberg Commodity Index are up 16 percent this year, the total return for funds linked to the gauge was about half that amount, data compiled by Bloomberg show. The performance gap has been widening since the first quarter of 2015 and is now the largest in five years, just as investors pour more money into commodities.

Other indexed products have a similar shortfall. Through Wednesday, the S&P GSCI Index had returned 2.5 percent for the year; spot prices for its constituent commodities were up about 14 percent. United States Oil Fund LP, the leading exchange-traded fund for crude investors, lost 5.5 percent while West Texas Intermediate oil, which it tracks, has risen 22 percent.

Part of the problem is how fund managers try to mimic price changes. Rather than buy raw materials that have to be stored, they use futures contracts. But when those expire -- sometimes every month -- returns suffer if contracts are replaced at higher cost. That occurs when markets are in contango, meaning that commodities for immediate delivery are cheaper than in the future, as they are now for everything from corn to crude.

“There are fees associated with those funds,” said Walter “Bucky” Hellwig, who helps manage $17 billion as senior vice president at BB&T Wealth Management in Birmingham, Alabama. “There’s an expense to holding that commodity, buying it and selling it. Where they don’t hold the commodity, they’re buying futures and rolling futures contracts, and so there’s expense there, too. The difference in return is something investors are willing to allow, simply because it gives them liquidity in a market.”

But the gap in the so-called roll yield -- an annualized measure -- has been widening. Global surpluses are keeping supplies cheap for now and fueling expectations that reduced output or more demand will boost prices in the future. The gross roll yield -- the difference between spot commodity prices and index returns tracked by Bloomberg -- touched minus 11.5 percent last month, the lowest since 2011, compared with just minus 3.9 percent a year earlier, data compiled by Bloomberg Intelligence show.

Rolling Contracts

The big reason for the difference comes from the use of futures, which are contracts for delivery of a commodity at a later date and a set price. For example, crude oil contracts traded in New York expire every month of the year, and each one is for delivery of 1,000 barrels. When the September contract expired on Aug. 22, it was valued at $47,050. Because oil for delivery in later months was more expensive at the time, the October contract on that day cost $47,410. That means it took an additional $360 to replace the old contract with a new one, so fewer new contracts were able to be purchased. Each group of indexes follows its own rules for rolling from one contract to another, typically a couple weeks before expiration.

As a result, while oil prices have rebounded this year with a gain of 22 percent, the index tracking the commodity has tumbled 6.4 percent. That translated to a gross roll yield for the Bloomberg Commodity Crude-Oil Index of minus 35 percent in August, the biggest discount to its underlying commodity since the financial crisis. Gasoline is at minus 19 percent, while natural gas is minus 45 percent.

“You’re rolling into those higher prices, so that’s killed you,” said Mike McGlone, a commodity strategist at Bloomberg Intelligence in New York.

At the same time, commodity investments are expanding at a record rate, according to Barclays Plc. Index-linked funds took in $54 billion in the first eight months of the year, topping the previous all-time high for that period in 2009, Kevin Norrish, a commodity analyst at the bank, said in a Sept. 15 research note.

Exchange-traded funds linked to commodities have seen a net inflow of $34.5 billion this year, including almost $30 billion for precious metals, data compiled by Bloomberg show.

“Institutional as well as retail investors should be acutely aware of the structure of the commodity product that they’re buying,” said Chad Morganlander, a Florham Park, New Jersey-based money manager at Stifel, Nicolaus & Co., which oversees about $180 billion. “Many of them are going to drift off the net asset value often. The problem is that many institutional investors have a difficult time buying the hard commodity, because it has to be placed in multiple accounts, which prohibits them from getting that true asset class that they’re trying to achieve.”

It wasn’t just energy that saw a disconnect this year. Sugar prices, based on the most-active futures contract, have rallied 49 percent this year, more than any of the 22 items tracked by the Bloomberg Commodity Index, while the index linked to the sweetener is up just 43 percent. Kansas City wheat futures fell 9.9 percent this year, but the index tracking it tumbled 21 percent.

UBS Group AG owns the Bloomberg Commodity Index (‘BCOM’). Bloomberg LP, the parent of Bloomberg News, is responsible for governance, calculation, distribution and licensing of the bank’s commodity indexes.

Gold Buying

Precious metals, which tend to have lower roll yields, are faring better. There’s little difference between the index and spot returns for silver, while gold has a roll of minus 0.9 percent, according to the data compiled by Bloomberg.

Roll yields don’t always detract from returns. When prices are less expensive in the future, the cost of replacing expired contracts is low. In the 1990s and 2000s, when growth in emerging markets led to commodity shortages, indexes actually outperformed the materials they tracked, according to McGlone.

“It’s just the cost of doing business, and it will always cycle back," he said. “The question is when."

For fund investors, roll yields may simply reflect the cost of not having to store the physical commodities. “You could buy up all that oil or gas or metals and avoid it," said Craig Pirrong, a professor at the University of Houston’s Bauer College of Business. “But it’d be pretty hard to fit in your basement."

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