We’ve written before about the risks of investing in commodity trackers. The trouble is that, for a large part of the exchange-traded commodity (ETC) market, the shape of the commodity futures curve (effectively the price of contracts that allow you to buy or sell commodities in the future) has more impact on your returns than the movement in the price of the underlying raw material.
The chart below, from ETF issuer Source, makes this point clearly. The black bar shows the 2010 return for S&P’s GSCI price index for the relevant commodity. That’s the movement in the headline or ‘spot’ commodity price over the 12 months. The red bar is S&P’s GSCI total return index – what an investor actually achieves by buying a futures contract on the commodity in question, then ‘rolling’ it into a new one each month as the previous version expires.
The reason for the chasm between the red and black bars is ‘contango’. This means that, when your commodity tracker sells the expiring futures contract each month and buys a new (longer-dated) one, it costs to do so. As the chart illustrates, contango cost investors nearly 20% in returns for five key commodity indices last year: wheat, corn, natural gas, grains and oil.
Contango reflects the cost of storage, financing and insurance, and is inevitable for many commodities. Unfortunately, many investors in commodity trackers seem to have ignored this. Cash-flow figures suggest they have piled into particular areas of the market, hoping to take advantage of spot-price falls, while ignoring the effects of contango on their likely future returns.
Natural gas trackers – the 20% fall in the commodity’s spot price in 2010 doubled to a 40% loss after the costs of rolling futures were taken into account – are a good illustration of this. In September 2009, the spot gas price fell to under US$3 per million British thermal units (MMBtu). This drew many investors to ETF Securities’ natural gas ETC – NGAS – which topped $1bn. But even though the spot price now exceeds US$4 (it’s up over 30%), NGAS’s price is 52% lower than at the end of September 2009.
The lesson? If you’re buying an exchange-traded product, you must understand how indices work and how their returns are generated. If you don’t understand the methodology, don’t touch it.
• Paul Amery edits www.indexuniverse.eu