Commodity Futures ETFs: A World of Hurt

Investing in commodity futures still paid in the 1980s and '90s, even as prices fell. But now...?

INVESTORS CHOOSING commodity futures – and that includes all the people who own commodity-future ETFs, aiming to track the upside in raw material prices – are in a world of hurt right now, writes Matt Hougan at Hard Assets Investor.

It's bad enough that spot commodity prices are crashing. Oil is down nearly $100 from its highs. Copper and other base metals are down 50% or more. Gold has slipped some 25% from its Dollar-top in March, while silver has dumped almost 60%.

But commodity investors using higher-risk futures to leverage their exposure have lived through falling commodity prices before and somehow come out okay. In the 1980s, for instance, the S&P GSCI Spot Commodity Index delivered annualized returns of minus 1.37% for the entire decade.

Yet investors in the S&P GSCI Total Return Index actually earned 10.67% per year during the '80s.

How? Because, as we've written before, there are three sources of return on a fully collateralized commodity futures index:

1. Spot return: Changes in the live market price (such as Spot Gold) for the underlying commodities;
2. Cash yield (collateral return): Interest income on collateral. Futures are inherently leveraged, so a fund only needs to put up 5%-10% margin to gain its commodity exposure, with the remainder invested in safe collateral, typically short-term Treasury bonds that pay an income.
3. Roll yield: The return (or loss) gained from "rolling over" a futures portfolio. Running a position means selling those contracts that expire this month and replacing them with contracts that expire next month (or the next quarter, depending on the commodity). Contracts may be either more or less expensive than current spot prices, creating either a positive roll yield (a situation called "backwardation") or a negative roll yield (a situation called "contango").

Each of these returns is critical to commodity futures index returns. The table below shows the roll each type of return made to the S&P GSCI Commodity Index over the past few decades. (The data is only through March 31, 2007, the latest available.)

S&P GSCI Annualized Return
	1970s	1980s	1990s	2000-07
GSCI Spot Return	9.05%	-1.37%	-0.63%	12.88%
GSCI Cash Yield	6.67%	9.52%	5.11%	3.20%
GSCI Roll Yield	4.24%	2.44%	-0.53%	-4.67%
TOTAL RETURN INDEX	21.25%	10.67%	3.89%	11.05%

Not surprisingly, the best situation for commodity futures indexes is when all three types of returns are working together, as happened in the 1970s.

During the '70s, the spot return, cash yield and roll yield were all positive for commodity future investors. But even when one of the returns falters – as the spot return did in the 1980s and 1990s, when prices fell (the roll yield also turned negative in the '90s) – investors still did alright, because the other sources of return provided ballast.

Unfortunately today, however, investors find themselves in exactly the opposite position today: Everything is working against them. And in a major way.

• Spot prices across the commodities complex have collapsed, and show little sign of a fast near-term rebound;
• The cash yield from collateral is terrible too. Three-month Treasury bonds were yielding 0.01% at the end of November, according to the Federal Reserve. (No, that is not a misprint.);
• And the roll yield? That is awful too.

Consider the DB Commodity Index. It's both the simplest broad-based commodity index – comprising just six commodities, compared with 24 for the S&P GSCI – and the benchmark for the most popular broad-based commodity ETF, the PowerShares DB Commodity Index Fund (NYSEArca: DBC).

If you look at pricing for the six commodities contracts in the DB Commodity Index, you can make a rough calculation of the roll yield by comparing the price of the current contract (which the index tracks today) with the price of the next-month contract (which the index will "roll into" when the current contract expires). Then, you simply annualize the cost or benefit and see what impact that will have on the index as a whole.

The chart below highlights the calculations. And let me tell you, it isn't pretty!

DB Commodity Index Contango: December 2, 2008
	Weight in Index	Jan. Contract (*=Dec.)	Feb. Contract (**=Jan. ***=Mar.)	1-Month Per Cent Change	Weight-Adjusted Drag, Annualized
Light Crude	35%	46.96	48.43	-3.13%	-13.15%
Heating Oil	20%	1.5935	1.6227	-1.45%	-3.49%
Aluminum	12.5%	0.7885	0.7960	-0.95%	-1.43%
Corn*	11.25%	332.4*	348.2***	-1.58%	-2.14%
Wheat*	11.25%	509.6*	528.4***	-0.89%	-1.20%
Gold	10%	781.30*	782.10**	-0.10%	-0.12%
TOTAL	100%	N/A	N/A	N/A	-21.53%
Source: NYMEX and CBOE; data as of close, 12/1/08

Based on current prices, the fund is facing a 21.56% annualized headwind over the next year. This means that, even if commodity prices stabilize, this index will decline by more than 20% over the next year if the contango situation holds and the roll yield stays so wildly negative.

Remember: There is essentially zero collateral return being paid by Treasuries to cushion this blow. That makes for a very, very unfriendly outlook in commodity future ETFs.

Where to turn? Besides looking at the individual commodities themselves, I believe commodity stocks – operations such as Gold Mining companies, plantations, or oil drillers – now have many of the factors working against commodity futures actually working in their favor right now.

Take yield, for instance. While Treasury bond yields have collapsed, yields on stocks are at decade highs. The S&P 500 is currently yielding 3.5%, and ETFs like the iShares S&P North American Natural Resources ETF (NYSEArca: IGE) or the Market Vectors – Hard Assets Producers ETF (NYSEArca: HAP) are yielding between 1.5% and 2.0%.

The fact that the futures markets are in contango doesn't necessarily mean good things for commodity stocks, of course; it generally means there is a surplus of commodities in the marketplace. But there is no direct impact, and generally, the markets should already have priced the impact of that surplus into equity prices.

All in all, it's an important reminder that commodity futures are not like commodity stocks in any way. The structural returns in commodity futures can be looked at, evaluated and predicted (at least over the very short term). Investors who ignore these forces – who figure that concepts like contango and backwardation can't possibly have an impact on their returns – do so at their peril.

There are moments when it makes great sense to be invested in commodity futures, and moments when commodity stocks seem a better bet. Right now, the choice seems to be simple.