FT Alphaville with a great post "Is ‘cash for commodity’ the biggest trade in town?" explaining why commodity curves are in contango (demand from passive indexers) and the benefit to producers (a cheap source of financing). I have been sitting on the below post explaining how this translates into an investment in a passive commodity strategy (hint... not good) so I thought the time was right to finally post it.
Wikipedia explains roll yield, so I don't have to:
Said another way, backwardation means the futures price is below the current spot price (i.e. the curve is downward sloping), thus the investor gaining exposure via futures will outperform the underlying spot market (all else equal). Contango means the exact opposite situation (this was explained recently regarding the VIX ETN VXX in the EconomPic post When ETNs Attack). In addition, as explained by FT Alphaville, this negative drag is the "subsidized financing" received by commodity producers "selling" their commodities in the futures market.The roll yield is the yield that a futures investor captures when their futures contract converges (or rolls up) to the spot price in a backwardated futures market. The spot price can stay constant, but the investor will still earn returns from buying discounted futures contracts, which continuously roll up to the constant spot price.
Note that in case of a market in contango, the roll yield is negative - since the price of the futures contract trades higher than the spot price, and rolls down to converge towards the spot price.
How much of an impact does this have? Let's take a look at the impact via the excess roll yield of the S&P GSCI Commodity Index futures vs. spot.
As can be seen above, the futures market has consistently underperformed the spot market since mid-2004. By how much?
A lot...
Jake, would be interesting to see you put the risk-free interest rate on the other axis of that excess roll yield chart.
ReplyDeleteYou may have seen Businessweek had an article on this topic in the July 26-Aug 1st edition. I thought it was very interesting and kind of funny that you covered this topic just a couple weeks beforehand. Your post definitely gave me a solid introduction to a topic I'd never heard of, and helped immeasurably in my understanding of the magazine article. Thanks, and keep up the good work. :)
ReplyDelete