Along with any successful product–financial or otherwise–comes a surge in interest and increase in scrutiny. And while the majority of the feedback on success stories is inevitably positive, the enhanced visibility and uptick in usage can serve up a backlash as well. That’s exactly how the impressive development of the commodity ETF space has played out; the billions of dollars that have flowed into these securities over the last two years serve as a testament to the tremendous popularity of securities offering easy, efficient exposure to a previously hard-to-reach asset class [see Many Uses Of Commodity ETFs].
But even as the majority of investors has embraced commodity ETPs, these funds have received a fair amount of negative (and often unwarranted) press as well. In recent months, some investors have expressed frustration with the performance of commodity ETPs that utilize futures-based strategies, expressing disbelief that share prices haven’t been moving in lock-step with the spot price of the underlying commodity. BusinessWeek recently profiled a number of these tales in a feature story, going so far as to issue a blanket warning against investing in commodity ETFs. (The complaints against commodity ETFs are baseless and the “woe-is me” tales recounted reflect poorly only on the investors who were apparently too lazy to do anything in the way of due diligence–but that’s a story for another day.)
As many investors know (and as some have learned the hard way), returns to futures-based commodity products depend not only on the chance in the spot price of the underlying commodity, but on the slope of the relevant futures curve. Because these funds obviously don’t want to take physical delivery of cattle or crude oil, holdings are “rolled” as they approach expiration; in other words, the fund sells near-month contracts and buys up longer-dated contracts.
Contango has become a four-letter word to some investors, representing an environment in which commodity funds face stiff headwinds from an upward-sloping futures curve. It is this phenomenon that is the cause for the “disappointing” performances of many futures-based commodity funds, creating a gap between the return on the ETF and the hypothetical return on an investment in the spot price of the physical commodity.
The Other Side
There are horror stories of investors flying into the wind, leading some to believe that a futures-based strategy will always underperform the spot price. But believe it or not, there are two sides to this coin. Just as contango can eat into returns, backwardation in futures markets can work for investors. When long dated futures are cheaper than those closer to expiration, commodity ETPs can generate a positive “roll yield” each month, essentially selling high and buying low.
Backwardation is relatively rare in commodity markets, in part because futures prices build in expenses related to storing the underlying commodity. But it’s not unheard of, as demonstrated by the current market for sugar futures. After a major rally in sugar prices in recent months, the market is clearly expecting prices to pull back, as reflected by the consistent downward slope in the futures curve. October 2011 contracts are currently about 15% cheaper than near-month contracts, meaning that a futures-based investment strategy will likely outperform the hypothetical spot investment.
So an investment in sugar is an interesting opportunity. If prices hold steady, a futures-based strategy should perform pretty well, boosted by the yield picked up during the roll process. To be clear, backwardation is no guarantee of positive returns. In fact, a futures curve is often downward sloping because the market expects the price of the underlying commodity to fall.
For investors looking to play sugar futures, the iPath Dow Jones Sugar ETN (SGG) is the best bet. The index to which this ETN is linked consists of a single ICE sugar futures contract, meaning that SGG has the wind at its back. SGG has had an up-and-down 2010, plummeting in the first few months of the year only to rally by close to 40% over the last three months. Investors are clearly expecting sugar prices to pull back in coming months as the harvest approaches, but SGG could perform well even if the return on the spot commodity is negative.
Disclosure: No positions at time of writing. Photo courtesy of Rufino Uribe.