For most of the 19th century, commodities were used and understood solely by farmers, miners and the companies that owned them. Now, of course, investors and their advisors have increasingly recognized the potential benefits of investing in this asset class. These benefits include a low correlation to the broad equity markets, strong relative performance over the past several years and a hedge against inflation. As a result, new products have emerged that have made it easier and much less expensive to invest in commodities, including both commodity-focused mutual funds and ETFs.
But in many cases, the returns delivered by these new vehicles have not matched investor expectations. In large part, this is caused by factors understood well by experienced commodity traders, but perhaps less so by some advisors and investors - the return-reducing impact of contango and roll yield.
Put simply, this has to do with the fact that traditional commodity indexes and funds, with their reliance on short-dated futures contracts, can experience significant performance drag. Typically, this occurs in an environment where prices are rising as existing contracts are expiring and need to be rolled into more expensive, longer-dated contracts. The gap between expectations (rising performance) and reality (dragging performance) has led these vehicles to be labeled "first generation" investments.
Recently, however, a new universe of next generation commodity indexes and funds has been brought to market seeking to minimize the effects of contango. These investments take a rolling reinvestment approach that is less susceptible to the performance drag stereotypically associated with contango. By design, these indexes are diversified across multiple commodities and maturities in order to minimize exposure to the front end of the futures curve.
The UBS Bloomberg Constant Maturity Commodity Total Return Index, for example, diversifies across 28 commodity components and spreads its exposure across the liquid futures curve. The chart below depicts how this index has performed over the last five years versus the broad equity market, as represented by the S&P 500, and two of the most widely followed traditional commodity benchmarks: the S&P GSCI and the DJ-UBS Commodity Index.
For investors and advisors eager to add to or adjust their commodity allocations, the contango-fighting approach of a next-generation commodity product may be worth a closer look.
Kristen Capuano is a marketing director at Van Eck Global. She focuses on product development.