Dynamic exchange traded funds that implement a “backwardation” strategy may provide investors with better exposure to commodities, compared to static funds that track conventional indices, according to a Morningstar analyst.
“A long-only position in commodity futures is not always expected to provide an excess return above the risk-free rate, as is the case with stocks and bonds,” writes ETF analyst Samuel Lee for Morningstar.
Commodity futures-based ETFs generally receive a favorable windfall when the futures market is trading in normal backwardation – later-dated futures trade at a lower price than the spot price, which contributes to greater returns when a fund rolls the yield, or sells maturing futures for longer-dated futures. [List of Top Commodity ETFs]
However, the average roll yield on 12 major GSCI commodity futures between January 1983 to January 2012 has been negative, Lee notes. This state of contango, the opposite to backwardation, contributed to lower returns. [Five Things to Know About Commodity ETFs]
According to the theory of storage, backwardation occurs when a commodity’s inventory levels are low and contago occurs when levels are high.
In a Financial Analysts Journal article, Claude Erb and Campbell Harvey contend that the risk-free rate, spot-price return, roll yield and diversified return are pressuring the performance of commodity futures.
The risk-free rate is already low, so collateral on futures won’t provide much cash return. Spot-prices are elevated because the markets anticipate high future commodity demand. Over the last five years, futures have been in a state of contango. Correlation between commodities is dampening diversification returns.
Lee, though, singles out two ETFs provide exposure to futures in backwardated markets with high roll yields:
- PowerShares DB Commodity Index Fund (NYSEArca: DBC) rebalances annually to include futures contracts that provide the highest implied roll yield.
- USCommodity Commodity Index Fund (NYSEArca: USCI) rebalances monthly to pick out the seven most backwardated contracts and seven highest returning contracts.
PowerShares DB Commodity Index Fund
For more information on commodities, visit our commodity ETFs category.
Max Chen contributed to this article.
Article corrected to reflect DBC rebalances annually, rather than monthly.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.