Exposure to commodities is through futures contracts. This introduces the question of ‘roll yield’.
The big story over the past few months has been the continued strong performance of commodities, notably energy. Natural gas prices have surged, while the price of oil has once again broken $80 per barrel.
When it comes to broad basket commodity options, there are a wide variety of choices that track different commodity indices. Probably the most popular commodity index is the Bloomberg Commodity Index. This is tracked by the L&G All Commodities ETF (LSE:BCOG) and the Invesco Bloomberg Commodity ETF (LSE:CMOD). This index has allowed both ETFs to produce a total return of just over 21% over the past six months.
Another popular index for broad commodity exposure is the Refinitiv/CoreCommodity Index. This is tracked by the Lyxor Cmdts Rfntv/CrCmd CRB TR ETFAcc€ GBP (LSE:CRBL). It has provided a return of 23.5% over the past six months.
When the weightings of the two indices in question are compared, the difference in performance makes sense.
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In August this year, the Bloomberg Commodity Index had a weighting of 36% towards energy, 28% towards agriculture, 15% towards industrial metals, 15% towards precious metals and 5.4% towards livestock. This meant that compared to the Refinitiv/CoreCommodity Index, it was slightly underweight energy.
In comparison to the Bloomberg index’s 36% weighting to energy, the Refinitiv/CoreCommodity Index had a 39% weighting. So, the Refinitiv/CoreCommodity Index (and the ETFs tracking it) were in a better position to gain from the recent dramatic rise in energy prices.
The Bloomberg index was also more overweight metals. Its combined weighting of both industrial and precious metals was above 30%. The overall metals exposure of the Refinitiv/CoreCommodity index is 20%. Metal prices have struggled over the past couple of months owing to fears about a slowdown in economic growth in China, particularly following the dramatic collapse of the giant property developer Evergrande (SEHK:3333).
‘Roll yield’ explained
However, broad basket commodity exposure is not just about the weighting to different commodities. Exposure to commodities is through futures contracts. This introduces the question of ‘roll yield’.
Broad basket commodity ETFs will gain exposure through futures contracts. When these expire, they will need to buy replacement contracts. If a fund invests in front month contracts, it gains exposure to the nearest contract on the futures curve. That is, the one with the shortest maturity. This approach is designed to give maximum exposure to the spot price of the commodity. Each time the front month contract nears expiration, the ETF will ‘roll’ on to the next contract, which then becomes the new front month contract.
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Usually, the longer dated a contract is, the more expensive it is (‘contango’). As a result, broad basket commodity ETFs often end up ‘rolling’ into the next, slightly more expensive futures contract, incurring a small loss. Some ETFs, however, have tried to get around this by using an ‘optimised roll’ strategy. An optimised roll means that the index follows a strategy to maximise the positive roll yield and minimise the negative roll yield impact where possible. The futures contracts will be selected with this mind, rather than blindly buying the next shortest-dated maturity contract when their current ones expire.
Investors can access the optimised roll strategy by using the WisdomTree Enhanced Cmdty ETF USD GBP (LSE:WCOG), a member of interactive investor’s Super 60 list. This ETF has the same commodity weighting as the Bloomberg Commodity Index, but with the maturity of its futures contracts actively decided with the aim of outperforming over the long term.
However, when there is scarce supply or strong demand, as we have seen lately in energy markets, shorter-dated contracts can start trading at a premium. This means the market is in “backwardation”. It also means that ETFs simply rolling on to the next futures contract have a positive roll yield. Over the past six months, this has broadly worked better than attempts to follow an optimised strategy.
As a result, the WisdomTree Enhanced Commodity ETF has slightly underperformed, producing a return of 18%. However, when markets return to more normal conditions (i.e. contango), the hope is that the optimised strategy will produce better returns.
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