Commodity ETFs: Next-Generation Roll Strategies

In "Commodity ETFs: Three Sources Of Returns," we discussed why—for many commodities—you can’t buy the physical commodity itself, and while futures may be an imperfect way to get exposure, it’s oftentimes the only option. In that article, we also specified three components of futures returns: changes in the spot price; the roll cost or yield; and interest income.

Two of those components are straightforward—the spot price; and interest income. There’s very little any ETF can do to affect those. But an ETF can have a significant impact when it comes to managing roll costs, and that’s what we take a look at in this article.

The first and most basic commodity futures-based strategy is simply a front-month roll. An ETF will hold the futures contract that is closest to expiration—the front month—before selling its position and buying the second-month contract sometime before the front-month contract expires.

The benefit of this strategy is that investors receive the closest exposure one can receive to the spot price of a commodity, as the front-month and spot prices tend to move closely together. However, because this type of strategy involves frequently rolling from one contract to the next, it’s significantly affected by contango and backwardation.

If a commodity is in contango—depending on the size of that contango—roll costs could add up quickly, eating into any increases in the spot price. On the other hand, as we’ve stated before, backwardation will supplement investors’ returns.

The second strategy some exchange-traded funds employ is a laddered investment, in which the ETF holds a series of futures contract months. With a laddered position, the ETF minimizes roll costs because it only has to roll a portion of its contracts (the front-month contract if it is a holding) in any given month.

On the flip side, an ETF using this strategy may provide returns that diverge from spot prices by holding contracts further out on the futures curve, which tend to be less volatile and have less of a correlation with spot prices.

The third category of investment strategy is the optimized strategy. ETFs that use this approach employ a rules-based process to select the futures contracts they hold. Generally, such ETFs attempt to minimize costs (and maximize yields) by rolling into contracts with the mildest contango or the steepest backwardation.

Like the laddered strategy, the optimized strategy may minimize roll costs, but at the expense of exposure to movements in spot commodity prices. Thus, these types of strategies are more suited for longer-term investment horizons. Short-term traders and speculators are more likely to find the exposure they want in an ETF that uses a front-month strategy.

Next: Gold Miners Vs. Gold

Other Articles Of Interest

Commodity ETFs: Why You Can't Buy Spot Oil: A Guide to Contango And Backwardation
How Are Commodity ETFs Taxed?
An Introduction To Asset Classes