Commodities: Focus on Rolls Not Spot

Following up on yesterday's "Natural Gas Pops 3.6% Ahead of Tomorrow's October Expiry", a reader sends us this John Kemp piece, from Reuters:

Roll returns rather than spot price movements have been a much more significant source of profits and losses for commodity investors over almost any time horizon.

Yet most investors still formulate their strategy in terms of outright price moves rather than the spreads, missing out on the most important source of long-term performance.

Strategies with the most explicit focus on roll returns, such as the SummerHaven Dynamic Commodity Index offered by U.S. Commodity Funds, which had $432 million invested at the end of June, account for a tiny fraction of the $50 billion invested in all commodity-focused mutual funds or the nearly $200 billion invested in indexing strategies as a whole.

Over the 10-30 year horizons that most interest pension funds, roll returns may be the only sustainable source of returns from commodities.

But given the theoretical and empirical importance of roll returns, it is surprising how few index products have been designed specifically to maximize them.

In principle, it should be possible to offer investors a product which targeted roll returns specifically and is neutral to spot prices, by investing exclusively in spreads, with the aim of capturing scarcity premiums in the market while avoiding exposure to cyclical variations in commodity prices.

Most of physical trading houses already claim to operate this way (with positions in the spreads rather than the outright directional plays). But as investors question whether the commodity super-cycle has peaked or plateaued, it would make sense for other investors to contemplate the same strategy.

ROLLS DOMINATE
By now most investors are aware that it is not possible to achieve returns based on the spot price of WTI or a basket of commodities.

But few investors appreciate just how significant roll returns are. In practice, rolls dominate all other sources of performance over the medium and long term.

Charts 1 and 2 show spot prices and actual returns to investors from a long position in WTI futures or a diversified basket such as the Standard and Poor's Goldman Sachs Light Energy Index. In both cases, once roll profits and losses are taken into account, actual returns diverge sharply from the spot price....MORE