Riding The Wave

September 01, 2005

Roll Yield (Backwardation/Contango)

In order to replicate a given index, a portfolio manager will buy futures contracts representing the required exposure in the underlying components. At expiration, a long holder of commodity futures will be assigned delivery of the underlying physical commodity. In order to avoid this and continue to maintain the desired exposure, the position must be 'rolled' to more deferred expiration contracts. Each of the indexes has rules which specify how this roll is to be carried out.

The roll highlights an important dynamic in trading futures-backwardation and contango (also known as carry). These terms are used to describe the shape
of the price curve as you move from spot prices to the more deferred expiration contracts. Markets that are in backwardation exhibit spot and near spot prices
that are higher than the more deferred contracts. In contango markets, the near contracts are priced at a lower level than the more deferred. As a general rule, a commodity that is not easily stored will trade in backwardation. A commodity that has acute demand/shortage will also trade in backwardation.

Figure 10

Depending upon the price differential between the near and deferred contracts, the roll of futures contracts will result in the new average owned price for a commodity being higher or lower then the average price being replaced.

A quick example on the differences in the two market conditions that may exist during a roll period is shown here.

In a contango market, the price of the deferred contract to be rolled into is higher than the near-term contract being rolled out of. Assume a portfolio manager is long June Coffee futures contracts at an average price of 110.00 (Figure 10). When it comes time to roll the position, the manager would roll the June futures out to the December contract. The December contract is priced at 117.00, and the new average price of Coffee after the roll activity would be 117.00. Obviously there is no inherent profit or loss associated with this activity; in simple terms, a new base price for the Coffee position has been established.

In a backwardated market, the price of the deferred contract to be rolled into is lower than the near term contract being rolled out of. Using High-Grade Copper as an example, suppose a fund owned July Copper futures contracts at an average price of 154.00 (Figure 11). When it comes time to roll the position, the fund would roll the July futures position out to the September futures contract. The September contract is priced at 146.00, and the new average price of the Copper contract after the roll activity would be 146.00. Again, there is no inherent profit or loss associated with this activity, simply a new base price.

There has been a great deal of discussion on the actual benefit of rolling into backwardated markets and of the implied cost of rolling into contango markets. A casual observer could conclude that an investor is better off getting into a lower price contract than a higher one. But as stated previously, there is no yield in the roll activity itself. As an example, assume a particular market is backwardated during a roll period. The portfolio manager will be required to roll a specific dollar amount of exposure. The manager will sell fewer contracts at a higher price and replace them with more contracts, albeit at a lower per-contract cost.

Crude in Contango

When discussing the return associated with the roll yield, the energy sector has been the primary focus. Crude and the other energy sector products have contributed the most to this portion of the overall return. There are several reasons for this:

•  The energy sector constituents are difficult and/or expensive to store. This effects the shape of the forward price curve.

•  Futures contracts on energy components are listed serially - there are 12 expiration contracts every year. Therefore, depending on the index rules, these positions may be rolled with more frequency than other sectors.

This situation, however, may be changing. Figure 12 highlights, crude markets, which have historically traded in backwardation, have recently been trading in contango. There is considerable speculation as to why this has occurre d . Theories range from the arrival of hedge fund and passive long fund money to the continued lack of refining capacity. Suffice it to say that the game is changing-at least for now. This change may have profound consequences on future performance of the various indexes. Specific differences in the mechanics of the indexes, such as roll frequency and contract selection, will be important factors in what effect this new reality may have on future performance.

Figure 11

Return On Collateral

To trade futures contracts, investors have to post funds into a margin account. These funds are generally held as short-term securities (90-day T-bills), which will generate a return to the investor. This component of return is only included in the Total Return calculation of the indexes.

Rebalance Returns

In order to maintain constant dollar weights, geometric indexes rebalance periodically. This activity, which is required by the constant-dollar-weighted structure of the geometric methodology, provides a portfolio manager the opportunity to enhance returns and can be the source of significant additional income.

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