Third time’s a charm: Increased roll yield seen through the third futures contracts
Bloomberg Professional Services
This article was written by Jim Wiederhold, Commodity Indices Product Manager at Bloomberg.
Long-only commodities investment returns can be attributed to spot, curve and carry components. In this blog post, we will discuss how holding exposure with the third futures contract in a commodities allocation has been shown to alleviate the typical negative roll yield associated with commodities.
Looking back over the past 20 years, we will see that the third futures contract (F3) outperformed a standard commodities benchmark allocation. We will also highlight the lower volatility associated with exposure further out the curve, which has been shown to reduce drawdown risk. Finally, we will explore the impact an allocation to commodities would have had on the risk adjusted returns of a traditional portfolio as we have entered a new macro regime in the 2020s with increased volatility in equities and fixed income.
An overview of sources of outperformance
A market-leading benchmark for a long-only commodities exposure using the 3rd month futures contract is the Bloomberg Commodity Index 3 Month Forward (BCOMF3). The total return of this index rose 3% in the first quarter of 2024, outpacing the headline Bloomberg Commodities Index (BCOM) by 81 basis points. Looking back over the last 20 years, BCOMF3 averaged an annual return 5% higher than the headline benchmark. Most of this outperformance could be attributed to a better roll yield return from positioning further out the curve when obtaining a long commodities exposure. Due to the cost of storage, most commodities futures curves tend to be in contango, meaning further dated contract prices are higher than near-expiry contracts. The curve slope tends to be less steep (less negative roll yield) the further out you go in general.
Third contract’s positions: Varying outcomes
The difference in the negative roll yield for commodities in contango, like copper and corn, had the biggest effect on returns compared to the smaller effect from commodities in backwardation like crude oil and coffee (Exhibit 1). This deferred positioning over time led to significant outperformance. Exhibit 1 shows the position of exposure of BCOMF3 in green versus headline BCOM in orange across several of the more heavily weighted commodities in the benchmark.
While it could have been beneficial to be in the nearby contracts when the forward curve is in backwardation or downward sloping, curves in contango tend to be steeper or create a much bigger negative roll yield. Hence, the benefit of the third contract’s position has been felt more with the commodities in contango than in backwardation. BCOMF3 experienced less roll yield drag then BCOM over time and the outperformance over the last 20 years can be seen in Exhibit 2. The cumulative outperformance was almost 100%.
In addition to the better roll yield contribution, BCOMF3 also exhibited less volatility and improved drawdown performance due to the less volatile nature of exposure to deferred commodities futures contracts. Spot and front-month futures prices tend to be the most volatile across the commodities complex as they react sharply to changes in supply and demand in the present.
Going further out the curve typically means moving to less volatile futures contracts across commodities markets. Exhibit 3 highlights the smaller percentage one-day price moves from the BCOMF3 versus BCOM (the benchmark) with more occurrences clustered near the peak in blue. BCOMF3 had 11 more days over the last year within a -0.5% to +0.5% daily range compared to the benchmark and the benchmark had the most outsized one-day moves positively and negatively near the ends of the histogram. The daily 30-day historical volatility of BCOMF3 was 14% versus 15% for the benchmark over the last five years.
The diversification benefits of commodities to a traditional asset portfolio have been demonstrated over the last few years. Whether or not a market participant is subscribed to the commodity super cycle narrative, it is clear the start of the 2020s are drastically different to the prior 2010s. Rates are no longer suppressed, inflation has come back, de-globalization is only continuing, and overall asset volatility may be coming back. Diversifying with an exposure to a real asset class like commodities could’ve helped a portfolio, particularly during periods of uncertainty and hawkish central bank activities as they fought inflation. Not only has BCOMF3 demonstrated better roll yield dynamics, and can be used as a suitable long-only expression for commodities exposure, but its performance has really stood out when compared to other asset classes, particularly in the last three years (Exhibit 4).
BCOMF3 is a benchmark for a long-only core holding of commodities that has led to better roll yield characteristics over time. It fits within Bloomberg’s roll enhanced family of commodities indices and appears to demonstrate the power of a simple approach to index construction. Geopolitical tensions may be ramping up through the course of this year and there are several important elections which could change the trajectory of asset prices globally. Diversifying a small portion of an allocation to commodities after a long run of equity outperformance could assist with portfolio performance in this new macro regime.
The data and other information included in this publication is for illustrative purposes only, available “as is”, non-binding and constitutes the provision of factual information, rather than financial product advice. BLOOMBERG and BLOOMBERG INDICES (the “Indices”) are trademarks or service marks of Bloomberg Finance L.P. (“BFLP”). BFLP and its affiliates, including BISL, the administrator of the Indices, or their licensors own all proprietary rights in the Indices. Bloomberg L.P. (“BLP”) or one of its subsidiaries provides BFLP, BISL and its subsidiaries with global marketing and operational support and service.