Sunday, August 14, 2016

Can you make money in commodities?

Can you make money in commodities? Some will say no if you cannot get the roll or income carry working for you. A  recent paper in the Financial Analyst Journal "Conquering Misconceptions about Commodity Futures Investing" describes the abject failure of commodity index investing over the last decade.

Billions may have been lost by investors that bought a commodity index basket as a inflation hedge or a form of asset class investment. This was based on a correlation with inflation that was not very strong and on the believe that the roll yield from backwardation would always exist.

There was the turn in the commodity super-cycle that worked against investors but the real investment widow-maker in commodities was the failure to properly account for the significant shift to contango from backwardation. If demand declines and inventories are high, the contango will be a significant drag on returns. 

The test period that got most investors excited about commodity investing was a period of strong backawardation so that investors through they would be receiving a positive risk premium from the roll of futures. The carry in commodities is time varying and not a given.

The commodity income was a key driver for returns over the long-run. Because investment in commodities is through futures, this carry component is critical to successful investing.

Knowing future commodity prices has not been as important and knowing the roll in the futures markets. The backwardation is a more consistent driver of returns. 

The backwardation is associated with low commodity prices. Income will be high from roll when price returns are low. The high prices at the peak of the super-cycle were also a time when income returns would be low.

The research says to forget about trying to come up with a forecast about commodity prices. It is more relevant to think about the shape of futures curve as a key driver of performance.

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