An investor can invest in commodities by taking a collateralized long position in commodities derivatives such as futures, forwards, and swaps. There are three primary sources of return:

 1. Collateral Yield: Long derivative positions require margin, which acts as collateral. Collateral yield is the return earned on this margin money. It's generally equivalent to T-bill returns.

 2. Roll/Convenience Yield: The roll/<a title="Storage, Convenience Yield, and Commodity Prices" href="https://financetrain.com/storage-convenience-yield-and-commodity-prices/">convenience yield</a> is the return earned from rolling the derivative contract forward. If the market is in <a title="What is Contango?" href="https://financetrain.com/what-is-contango/">contango</a>, the convenience yield will be negative, and the market is in <a title="What is Backwardation?" href="https://financetrain.com/what-is-backwardation/">backwardation</a>, it will be positive. This is because, in backwardation, the long investor can buy the commodity from a hedger at a price lower than the spot price.

 3. Spot Price Return: As the name suggest, this is the return from the fluctuation in spot prices. This again can be positive or negative.

Sources of Return from Commodity Investments

This video by Arif Irfanullah provides a very clear conceptual understanding of the concepts related to investments in commodities as a part of the CFA Level 1 syllabus. This video talks about
<ul>
	<li>Contango</li>
	<li>Backwardation</li>
	<li>Sources of return and risk</li>
	<li>Commodities in a portfolio</li>
	<li>Why is commodity index strategy considered active</li>
</ul>
<iframe src="http://www.youtube.com/embed/29JDz8om_kE?list=PL3566A64634F08956&amp;hl=en_US" frameborder="0" width="600" height="338"></iframe>

Investing in Commodities - Video

In the commodity markets, the relationship between spot prices and futures prices is explained using the concept of contango and backwardation.

Contango: Refers to the situation where the futures prices are higher than the current spot prices.

Backwardation: Refers to the situation where the futures prices are lower than the current spot prices.

Contango is a sign that the market participants are expecting the spot prices to rise in the future. On the other backwardation means that market participants expect the spot prices to drop in the future.

As an example, the oil prices exhibit contango, as the consumers of oil drive the prices up. However, the futures price cannot vary widely from the current spot price because a very wide variation could give rise to arbitrage opportunities. Imagine the futures prices for gold are very high compared to spot prices. In that case, an investor has a pure arbitrage opportunity, as he could buy the gold in the spot market, store it, and sell it in the forward market, hence making a clean profit. This is called a carry trade, and the futures price of such a commodity will limited by the value of full carry (i.e., the storage cost and borrowing costs). However, this rule won’t apply to all commodities, as not all commodities can be stored for a long time, and there could also be limitations on how much can be stored.

In the earlier times, many commodities used to have natural backwardation, as the producers of commodities would want to sell their products at lower prices. Backwardation can occur if the markets have oversupply situations and the buyers are able to dictate the prices. In the past Crude oil and Natural gas used to be in backwardation.

Even though some people consider backwardation as an abnormal activity resulting from supply inefficiencies, the economist John Maynard Keynes argued that in commodity markets, backwardation is not abnormal, but rather arises naturally from the fact that producers of commodities are more prone to hedge their price risk than consumers.

Contango and Backwardation in Commodity Markets

There are several benefits that commodities offer to a portfolio manager as a potential long-term investment option. Some of these points are highlighted below:
<ul>
	<li>Commodities have negative correlation with other markets such as equities and bonds, which makes it a suitable choice for diversifying the portfolio.</li>
	<li>In the past, both equities have exhibited similar risk-return profiles. There were positive returns from all the three markets – equity, bonds, and commodities – with commodities showing similar volatilities as equities. One can achieve overall risk reduction.</li>
	<li>Return-timing diversification: Over the long periods, the returns of the portfolios tend to accrue in short periods. Financial assets perform poorly during economic recover (later periods), and during periods of inflation shock and contractionary monetary policy. During these times commodities tend to perform better. This provides the benefit of return-timing diversification.</li>
	<li>Long commodity investments also act as a natural hedge for inflation exposure in long-term liabilities. It may not cover the entire inflation risk but a major part of it. This happens because commodity prices have high correlation with inflation. These commodities reflect prices in energy, metal, and agricultural commodities which are a component in calculating Consumer price Index.  Commodities are also effective in hedging unexpected inflation.</li>
</ul>

How Commodity Investments Can Help a Portfolio

In the equity portfolio management, indexing strategies are considered to be passive portfolio management strategies, since a portfolio manager just needs to follow the index and no active management is required.

However, the same is not the case with commodity index strategies which are considered to be active strategies. This is so due to several reasons that require the portfolio manager to manage the portfolio actively:
<ul>
	<li>Commodities index weighting change over time.</li>
	<li>The manager needs to manage the size of exposures to various commodity markets because positions are rolled over. The rolling methodology of the index dictates the rolling frequency of the portfolio.</li>
	<li>In order to maintain long exposure to changes in commodity prices, the manager will also need to close-out and re-establish derivative positions.</li>
	<li>The manager also needs to manage the short-term debt used for collateral of derivative positions appropriately.</li>
</ul>
Note that the correlation between different subcategories of a commodity index is almost zero. For example, there will be little correlation between cotton futures and oil futures. This helps in maximizing the rebalance yield.

Why Commodity Index Strategies are Active Investments

A portfolio manager can use several approaches to make commodity investments. There are three broad approaches: index fund, index-plus strategy, and active long-only strategy. Let’s look at each of these in details.

Index Fund Strategy

A commodity index fund is a fund that invests in financial products linked to a commodity index. Since investing directly in an index is not possible, a portfolio manager can do so by simply investing in an exchange-traded fund, buying/selling futures to replicate index performance, or entering into index swaps with investment banks.

Index-plus Strategy

In an index plus strategy, the portfolio manager aims at achieving returns above the index. There are several index plus funds following this strategy in the market. In this strategy, the portfolio manager will achieve superior returns through active management of commodity positions and underlying cash collateral. The common techniques are:
<ol>
	<li>High collateral return: Aggressively using the cash held as margin collateral.</li>
	<li>Roll management: Varying the timing of futures contract rolls from the benchmark, such as deferring contract rolls to take advantage of pricing differences in forward contracts.</li>
	<li>Rebalancing of portfolio</li>
	<li>Maturity management of futures contracts</li>
</ol>
Active Long-only Strategy

As the name suggests, in this strategy the portfolio manager maintains active long-only positions in commodities. The long only strategy does not use leverage and moves between cash and commodities based on the returns forecasts. Such a strategy would aim to exploit long-term relative trends of individual commodities.

Types of Commodity Investment Strategies

Investing in Commodities

This frontmatter description will appear below the title

COURSE

Investing in Commodities

Lessons

R Programming Bundle: 25% OFF