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50 48


Front month


2


In contango, rolling returns are negative, as front-month are below second-month contract prices.


3 4 5 6 7 8 9


month month month month month month month month Source: BofA Merrill Lynch Commodity Research


CHART 2


10% 8% 6% 4% 2% 0% -2%


Spot and Roll Returns of Various Rolling Methodologies YoY return


ALTERNATIVE INVESTMENTS


Curve placement strategies These are one of the most basic and popular ways to generate commodity alpha. In essence, they exploit market segmentation across different commodity forward curves. They aim to generate returns by taking advantage of the differences in hedging needs between producers, consumers and index trackers. In addition, curve placement strategies are rewarded for providing liquidity to market participants in less liquid parts of the forward curve. Commodity forward curves embed not just


1st-2nd 2nd-3rd Spot return 3rd-4th Roll return


Source: BofA Merrill Lynch Commodity Research Source: Bloomberg, BofA Merrill Lynch


4th-5th


expectations about future prices but also the net costs of carrying physical commodities over time. Storage costs and the cost of financing the storage purchases largely explain the shape of the curve in most commodity markets. Using the physical arbitrage argument, the curvature


CHART 3 (100 = price on 31st


400 300 200 100 0


Index Level (31/10/2002 = 100) MLCX A01E


MLCXA01 ER Index vs. DJUBS ER Index October 2002, from 31st


MLCX A01E vs DJUBS October 2002 to 30th June 2011) DJUBS


Oct-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 MLCX A01E


DJUBS Source: Bloomberg, BofA Merrill Lynch


of the forward curve should be determined by the cost of financing and storing a commodity for a month starting in a month versus that cost for a month starting three months from now. Hence, if renting a storage facility for a month starting a month from now is more expensive than renting a storage facility to be used in the future, then the cost of storage argument implies a concave forward curve. As shown in chart 1, in a contango market, because of higher curvature in the front end than further out in the forward curve, the roll returns are more negative in the front end than further out. Curve placement strategies take advantage of concavity in the forward curves by rolling long positions in commodity futures further out in the forward curve, as against rolling short positions in commodity futures closer to maturity. Bank of America Merrill Lynch has developed


CHART 4


MLCXALS Index = Long MLCXA01 Index & Short DJ-UBS Index (100 = price on 31st


October 2002, from 31st 175 150 125 100 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Source: Bloomberg, BofA Merrill Lynch October 2002 to 30th June 2011)


many commodity curve placement alpha strategies – MLCXALS, MLCXA6LS and MLCXY6LS are examples of strategies that take advantage of concavity in the forward curves by rolling long positions in commodity futures further out in the forward curve rather than rolling short positions in commodity futures closer to maturity. The indices rebalance their long and short legs on a monthly basis. DJ-UBS index rolls its commodity contracts from


the first month to the third month future. In contrast, MLCXA01 index invests in the same commodity underlyings and weights as that of the DJUBS index, but uses a roll schedule of rolling from the third month to the fourth month future. Since October 2002, MLCXA01 has outperformed the DJUBS index because of its efficient roll strategy (chart 3). MLCXALS index is a long-short market-neutral index which is long the MLCXA01 (more efficient) index and short the DJUBS (less efficient) index. Chart 4 shows the historical performance of the MLCXALS index (annualized return of 5.99 per cent with an annualized volatility of 2.03 per cent). Curve placement strategies also take advantage of market segmentation across the forward curve.


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