Commodity Oddity

"We are commodities brokers, William. Now, what are commodities? Commodities are agricultural products...like coffee that you had for breakfast...wheat, which is used to make bread...pork bellies, which are used to make bacon, which you might find in a 'bacon, lettuce, and tomato sandwich.'
--Randolph Duke (Trading Places)

One issue with owning commodity exchange traded funds (ETFs) that buy futures contracts is that they are impacted by 'roll yield.' Let's say an ETF owns crude oil futures contracts that expire at the end of August. Crude currently trades at $75. The September contract may be trading higher at $77, reflecting a condition known as 'contango.' Out month futes may be higher because of opinions regarding supply/demand, storage costs of holding physical crude, or other things.

Assuming that it is fully invested, the ETF can only buy ~98% of the original quantity of crude when it rolls its contracts forward (not counting any further slippage due to transaction costs). Stated another way, it loses about $2 per barrel when rolling. This is known as a negative roll yield. It should be apparent that negative roll yields will erode commodity ETF value over time--all else equal.

Of course, it is also possible to have a positive roll yield if out month contracts are declining in value. This condition is called 'backwardation' and happens from time to time. Positive roll yields would be accretive to fund performance.

When I first started trading the United States Oil Fund (USO), it didn't take long before I noticed the roll yield tracking error, which was considerable, and I haven't traded it since. That was 3-4 years ago.

Business Week recently ran a cover story slamming commodity ETFs for the roll yield losses. Nothing like being on the edge of the sword, BW!

Not unexpectedly I suppose, the tone of the BW piece is decidedly slanted against Wall Street, implying that investors were unknowingly rooked by ETF shysters. This is nonsense, of course, as the risks were printed on the 'warning labels' of these funds--if investors took the time to read them. Moreover, any fool that fails to closely study that he/she participates in are likely to lose.

Despite their problems, I've been able to employ commodity ETFs effectively using a few rules of thumb. Some commodity ETFs are backed by physical rather than futes (e.g., GLD, SLV) which eliminates roll yield concerns (altho it doesn't eliminate annual mgt fees). Some commodity ETFs trade baskets of commodities (e.g., DBC, RJI) which helps diversify roll yield profiles. Finally, I like to use commodity ETFs as trading vehicles rather than investment vehicles which, again, reduces roll yield effects.

Properly employed and intelligently managed, commodity ETFs can still add significant value.

position in SLV