ETF Univ: Commodity ETFs’ 3 Sources Of Return

ETF UNIVERSITY

Investors buying commodity ETFs focus on the prices of the commodities themselves but should remember that most ETFs don’t invest in commodities directly. Instead, they buy commodity futures contracts that have three sources of return.

The return on a commodity futures contract is the sum of: change in spot price + roll yield + collateral yield. Excess return indexes include the first two types of return, but only total return commodity indexes include the third source (collateral yield).

Spot Price
The spot price of a commodity is the price quoted for immediate or short-term delivery, and implies a direct investment in the physical commodity. In practice, “spot” delivery can be as far out in time as the expiry date of the next futures contract—up to three months forward.

Few investors or traders in commodities can take physical delivery of raw materials, which could incur significant storage and insurance costs. Those wishing to hold a long position in futures over time therefore have to sell (“close out”) positions in expiring futures contracts and reinvest their money into longer-term contracts.

But the prices of commodity futures contracts with longer-term expiration dates are usually quite different from the price of the nearest-term contract.

When a futures market is in contango, the price of the commodity for future delivery is higher than the spot price (longer-dated futures prices are higher than near-dated futures). A chart plotting the price of futures contracts over time is upward-sloping.

When a futures market is in backwardation, the opposite occurs (far-dated futures are lower than the spot or near-term futures price). A chart plotting the price of futures contracts over time is downward-sloping.

So an investor buying a commodity futures tracker must reinvest continually from expiring nearer-dated contracts into further-from-expiration longer-dated contracts.

When the market is in contango, this means selling out of futures at lower prices and reinvesting at higher prices, a policy that generates a negative roll yield.

Roll Yield
When the commodity market is in backwardation, a futures investor earns a positive roll yield by selling out of expiring contracts at higher prices and reinvesting at lower prices.

The expected changes in a commodity’s spot price and the roll yield earned by the investor in a commodity tracker should be seen as two sides of the same coin. This is because contango (an upward-sloping curve of futures prices over time) implies an expectation of rising spot prices (after adjusting for the cost of storage).

So some of the money you’ll lose as a result of the negative roll yield incurred by the index of a commodity that’s in contango may be offset by rising spot prices.

Backwardation generates a positive roll yield, but is typical for commodities whose spot prices are expected to fall over time.

Collateral Yield
The third component of a commodity futures investor’s return—collateral yield—arises because investors in commodity futures must set aside collateral. This collateral generates interest income, which is then reflected in the futures price. Only total return indexes include this source of return.

Of the three sources of excess return to a commodity futures investor, changes in spot prices and the roll yield are the most important. The relative importance of the components can change over time, too.

It’s advisable for potential commodity investors to understand all three sources of yield and what kind of index a product tracks.

SELECTED TERMS

Contango/Backwardation
These are terms seen across the commodity ETF space. They pertain to roll costs associated with moving from one futures contract to another. When an expiring futures contract is cheaper than—or trading at a discount to—the next month’s contract, the futures curve is in contango. Contango translates into roll costs to an investor (or an ETF) having to move from one contract to the next. The opposite of contango is backwardation, when the expiring futures contract is trading at a premium to the next contract. Contango and backwardation impact commodity futures and futures-based ETF returns. Many commodity ETFs try to optimize their roll strategy to circumvent the impact of contango on returns.

Counterparty Risk
It’s the risk an investor faces that whoever is on the other side of the deal might fail. For example, ETF issuers offer a pattern of returns for a given fee in an ETF wrapper . They can be a source of counterparty risk if they don’t deliver on what that ETF prospectus promises. Depending on the type of exchange - traded product, counterparty risk is higher or lower. Exchange-traded notes, which are debt instruments, pose counterparty risk associated with the institutions backing them and whether they can meet these debt obligations. ETFs that use a lot of derivatives contracts in their portfolios can also face counterparty risk stemming from the parties issuing these contracts.

Exchange-Traded Note
An ETN is a debt note issued by a bank. ETNs can access just about every corner of the market, and can often package complicated strategies, but they introduce counterparty risk associated with the issuing bank.

Grantor Trust
One of the most commonly used structures for commodity ETFs, a grantor trust is a physically backed trust that stores the physical commodity—say, gold bars or silver coins—in vaults while giving investors exposure to spot returns of that commodity. The biggest example of a grantor trust is the SPDR Gold Trust (GLD). By owning shares of GLD, ETF investors actually have claim to physical gold being vaulted in London.