Research by Moonraker Fund Management suggests that several of the commodity indexes tracked by exchange-traded products have significantly under-performed the spot prices of their underlying commodities over the last year, sometimes delivering double digit underperformance.
The findings highlight the impact of the “negative roll yield” and raise serious questions about whether investors should find alternative vehicles to invest in commodities over the long term.
Most commodity ETPs, including exchange-traded funds, commodities and notes, are designed to track the futures indexes of the underlying commodities rather than the spot prices. But many investors mistakenly assume that their ETPs track the latter of these two and often fail to understand why there are variations in performance.
Moonraker’s research shows that futures indexes tracking five commodities popular among investors have underperformed the spot prices of their respective commodities by significant margins over the year to 26 February 2010. Nor do the performances of futures indexes take account of the management fees charged by ETPs, which would reduce the returns to investors even more in practice.
The discrepancy in relative performances is most marked among fuel and soft commodities. Oil produced the biggest tracking error (-43.80 per cent) with wheat second worst (-16.51 per cent).
Metals, over the sample period, tended to have more favourable tracking errors: the DJUBS Copper Index was just 4.60 per cent down on the spot price, while the DJUBS Gold Index was -14.98 per cent. This is because the futures curve for metal commodities were generally flatter than for agricultural or energy commodities.
The lack of correlation in performances occurs when ETP providers buy futures contracts to track the prices of commodities. These contracts are sold and re-purchased at regular intervals, usually every one or three months. If the commodity is in the normal state of contango, whereby forward prices are higher than current prices, then the provider must sell a contract at the current lower price and pay a higher price to buy the new contract in order to continue owning a unit of the commodity. This loss is known as a negative roll yield. However, if the market is in backwardation, whereby forward prices are below current prices, then the ETP provider will pay less to roll over the contract.
Jeremy Charlesworth, chief investment officer of Moonraker and manager of the Moonraker Commodities Fund, says: “Investors really shouldn’t be buying into ETPs when the market is in contango, but commodity index ETPs do receive a considerable tailwind from a futures curve in backwardation.
“Some ETPs can suffer tracking error because of the index methodology used which might not be efficient in all market conditions. Also, some managers attempt to use contango-thwarting roll strategies to minimize slippage when markets are in contango but the evidence suggests that these strategies struggled over recent months. It has been an unusual year because the collapse in spot prices in 2009 put markets into deep contango from a state of backwardation the year before.
“But the point is that many investors think they are tracking the spot prices of commodities and cannot understand where the discrepancy in performance comes from. Many commodity ETPs are really short term trading vehicles and investors should avoid them if they want a long term exposure to commodities as an asset class. They should instead be looking for vehicles in which the fund manager has the flexibility to invest in commodities in a variety of ways, whether it be investing in ETPs when the time is right, shorting commodities and owning company shares.”