Financial Education

Commodities have very low correlations with traditional assets such as stocks and bonds, and therefore can be strong diversifying agents even though their long-term expected return is lower. In particular, commodities often rise during times of financial distress while other assets are falling and the diversification benefit is needed most.

Over the long term, commodity returns are explained by the business cycle, a convenience yield resulting from the ability to time consumption, and real options that allow the producers of commodities to adjust their production levels in response to prices.

Commodity investments, particularly those in storable commodities such as oil and metals, also offer a hedge against inflation. This is especially true during periods in which inflation rates change unexpectedly.

The total return for a commodity futures contract is made up of three components.

1. Spot return represents the change in spot price of the underlying asset. Since commodities tend to have positive exposure to event risk, it can make up a significant portion of the total return.
2. Collateral yield or collateral return arises because futures contracts do not require the entire cash position to be paid up front (only margin is due at the outset of the contract.) Collateral yield is the return earned by investing the remaining cash during the term of the contract.
3. Roll yield or roll return is generated as contracts roll forward in time due to the necessary convergence of spot prices and futures prices. A downward-sloping term structure (which is known as backwardation) results in a positive roll yield, and an upward-sloping term structure (known as contango) results in a negative roll yield.

In the June 2007 Journal of Banking and Finance, Miffre and Rallis compare strategies for investing in commodity futures based on short-term momentum and long-term reversal, based on a variety of formation and holding periods.

Momentum strategies based on selling past losers and buying past winners generated positive and significant returns in 13 of the 16 combinations of formation and holding periods, with a significant portion of that return being derived from short positions in the losers. These strategies generate positive alpha and have low correlations with the returns on equity or fixed income securities.

The reversal strategies do not exhibit consistent outperformance in this study.

As with any asset class, investments in commodities should be compared with an appropriate benchmark for risk and return. A number of commodity indices are in wide use, which all attempt to replicate the returns available to holding long positions in commodities. The indices can vary widely in terms of composition (which commodities are included), weighting scheme, and purpose. It is important to choose an index that matches the investment practices being used.

Since a futures contract is a zero-sum game (every long position is offset by a corresponding short position) it is not possible to market-weight a futures index. Instead, weighting strategies range from judgment-based methods, to equal-weight, to weightings based on world production levels. The benchmarks typically offer representations of both spot return and total return.

Investors wanting exposure to commodity prices in their portfolio can gain exposure either directly or indirectly.

Direct investment in commodities has traditionally taken the form of cash purchase of physical commodities such as metal, oil or agricultural products. The development of derivatives markets has resulted in most of the direct commodity transactions involving futures products. Direct investment obviously provides a direct link to commodity prices, but can require possession, storage, financing, insurance and transaction costs which are either paid directly or through the basis in the futures contract.

Indirect investment in commodities is typically manifest as buying the equities of a commodity producer such as a mining company. It does not provide a direct exposure to the commodity prices, in part because many producers uses hedges to control their own exposure.