COMMODITY INDICES
Figure 1: Components of Commodity Index Returns Goldman Sachs Reduced Energy Index
Percentage Annual Return 50 40 30 20 10 0 -10 -20 -30 Spot Return -40 -50 Roll Return Collateral Return
commodity indices launched by investment banks and other managers [first generation passive, second generation enhanced, and third generation dynamic] have essentially been an effort to recapture disappearing risk premiums. But the effort may be doomed to failure. There are now so many investors chasing the same risk premium that it may have effectively disappeared for the time being.
Who Pays Who For Risk? Keynes thought commodity
Sources: Standard & Poor’s, Reuters, J. Kemp
captured positive yield from their collateral and gains from rolling their index positions forward in mostly backwardated markets. But since 2004, roll yields have become uniformly
negative. Roll yields were the component of returns most closely associated with John Maynard Keynes’ theory of normal backwardation and the existence of a commodity risk premium. The commodity futures risk premium therefore appears to have evaporated.
The commodity futures risk premium seems to have shrunk or disappeared
Investors’ problems have worsened since interest
rates were slashed in 2008 because the collateral return from holding safe Treasury bills and bonds has also vanished. The various generations of
The Generation Game
The first generation of passive indices was based on fixed commodity weights and a standardised roll procedure. But first generation indices fell victim to their own success.
The sheer volume of money they attracted and trapped in
contracts nearing maturity and needing to be rolled forward drove markets for oil, natural gas and other commodities into a deep and persistent contango. Index investors found themselves paying a steep price to maintain their long exposure.
The second generation of enhanced indices was based on
fixed weights but shifted exposure forward along the futures curve and/or employed a more complex (and in some cases discretionary) roll procedure to minimise contango costs dragging on index performance. Enhanced indices reduced contango losses but prevented investors from capturing the benefit from backwardations arising from spot market tightness.
52 September 2011
producers would be prepared to sell futures contracts for less than their expectation of future spot prices (on average) to transfer
price risk to investors. Normal backwardation was essentially an insurance premium. Producers bought price insurance from speculators and investors who sold it. But the number of index investors anxious to sell
this type of price insurance has rocketed over the last decade – while there is no evidence the number of potential buyers (producers employing inventory or production hedges) has increased by a similar amount. In fact, the number of insurance buyers may have fallen as commodity producers embrace ‘no hedging’ strategies. The commodity futures risk premium seems
to have shrunk or disappeared. The market for commodity price insurance appears to have overcapacity. Increasingly, investors dominate both sides of the market – with macro and commodity focused hedge funds, as well as trend followers and small-scale speculators, most often on the long side, and physical commodity traders with inventory on the other. There are now so many index investors and other
holders of long futures positions that are paying a premium to remain long instead of receiving one – which explains why roll returns have shifted sharply negative in recent years.
Back to Square One ... Rather than capturing positive risk premium, commodity index investments have become a straightforward directional bet on prices. Spot price appreciation has provided all the returns to index investors every year since 2004 with the exception of 2006 and (just) 2008 (Figure 2). But there is no reason to expect commodity prices to continue rising indefinitely at a rate faster than
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