Long-only commodity indices derive their returns from several sources
Collateral Yield: In a long-only commodity index, futures positions are unleveraged, meaning they must be fully collateralized, usually with Treasury Bills. Therefore, a portion of the return will come from the underlying cash position that supports the futures contract. Some managers seek to actively manage this underlying cash position in order to enhance the overall return of products tracking the index. Others simply invest the cash in short-term Treasuries, which are then rolled over at maturity. Depending on the type of fixed income security used to collateralize positions in the long-only commodity index, the return on the underlying cash position could range from 2-4%.
There is some debate as to whether or not the yield on the underlying cash position should be included as a source of commodity index returns, because an investor could theoretically achieve this return by simply allocating cash to Treasuries and because this portion of return has no direct relation to the actual commodities. If this portion of the return were not included in the long-only indices, it would alter their long-term performance.
Rebalancing Yield: A second source of return from long-only commodity indices comes from what is known as the rebalancing yield. This portion of the return is attributable to the fact that commodity prices are not correlated with each another due to the varying factors that affect the price of each commodity. Because commodities do not rise and fall together, an index consisting of many commodities that is rebalanced regularly on a price basis is able to extract a return based on the tendency of commodities to revert to their mean prices. Historical data confirm that a price-rebalanced index will tend to extract a return from “buying low” and “selling high” the uncorrelated commodities.
Robert Greer, senior vice president and portfolio manager for the PIMCO Real Return Fund, estimates that according to historical data, a commodities index can earn a rebalancing yield of approximately 2.5% on a long-term basis. The frequency of rebalancing is of particular importance, as data has shown that indices that rebalance more frequently are able to extract a greater return than those that rebalance less frequently.
Roll Yield: In addition to these two sources of return, a long-only commodity index will have gains associated with the change in price of the underlying commodities and the futures contracts on those commodities. For example, as a contract nears expiration, it will be “rolled over” to purchase new contracts on the commodity. At the time the position rolled over, there will be a gain or a loss depending on whether the underlying commodity has risen or declined in value. This portion of return is known as the “roll yield,” and will depend in large part on whether the underlying commodities are increasing or decreasing in value as well as the allocations of various commodities in the index.
Risk Premium: Finally, participants in the futures market can earn an insurance (or risk) premium since the long position is absorbing price risk that commodity producers, who are natural sellers, do not want. There may often be an imbalance between those wanting to sell futures contracts (like a farmer) and those willing to purchase futures contracts (such as a cereal manufacturer). The consumer (buyer of commodities) has less price risk than the producer because the end user can raise prices on the final product.
Investors in the futures markets serve to balance the market demand and in return, they are compensated for providing liquidity and assuming price risk.18 As a result, the investor is able to extract a return and profit from participation in the market and achieve an inherent positive return, or a compensation for the risk assumed by the investor. This component of return is closely related to the gain or loss on the underlying futures contract discussed previously.
An investor purchasing a futures contract and holding it to expiration will capture some risk premium in the marketplace and will also have a gain or loss depending on where the price settles at maturity. While these components of return are shown separately, they are closely linked and in some cases indistinguishable.
In evaluating the sources of long-only commodity index returns, we believe it is important to focus on those sources that relate specifically to an investment in commodities. As figure 1 shows, the key sources of return for a long-only commodity index are the gain or loss on the underlying futures contracts, the rebalancing yield, and a risk premium for providing liquidity to the market. The yield on the underlying cash position may or may not be considered as a source of returns to the index, although returns of the major indices include these in their total return calculations.
In the final analysis, the two main sources of return that relate directly to commodities are the gains and losses on the underlying futures contracts and the return that will come from providing liquidity to the markets due to the nature of futures contracts and the commodities markets. When analyzing long-only commodity index returns, it is important to focus on those sources that are related to commodities rather than those that are exogenous to the actual changes in prices of the futures contracts.
Investors who consider an allocation to commodities should also recognize the potential volatility of returns for long-only indices. In 1998, for example, the GSCI declined by 35%, a substantial one-year loss that was driven in large part by difficulties in the emerging markets. While this is comparable to the 30% decline in the Russell 2000 Growth Index during 2002, commodities do not provide the same long-term upside as small cap equities, with the key exception being energy related commodities, which have provided higher real returns. The longer-term standard deviation of the GSCI is close to 20% and, while this index has shown strong gains, the impact of the oil crisis of the 1970s heavily influenced the returns of this index. For example, from January 1970 through January 1980, the GSCI increased at an annualized rate of 21.8%, in large part due to the steep rise in oil prices during this time period.
Collateral Yield: In a long-only commodity index, futures positions are unleveraged, meaning they must be fully collateralized, usually with Treasury Bills. Therefore, a portion of the return will come from the underlying cash position that supports the futures contract. Some managers seek to actively manage this underlying cash position in order to enhance the overall return of products tracking the index. Others simply invest the cash in short-term Treasuries, which are then rolled over at maturity. Depending on the type of fixed income security used to collateralize positions in the long-only commodity index, the return on the underlying cash position could range from 2-4%.
There is some debate as to whether or not the yield on the underlying cash position should be included as a source of commodity index returns, because an investor could theoretically achieve this return by simply allocating cash to Treasuries and because this portion of return has no direct relation to the actual commodities. If this portion of the return were not included in the long-only indices, it would alter their long-term performance.
Rebalancing Yield: A second source of return from long-only commodity indices comes from what is known as the rebalancing yield. This portion of the return is attributable to the fact that commodity prices are not correlated with each another due to the varying factors that affect the price of each commodity. Because commodities do not rise and fall together, an index consisting of many commodities that is rebalanced regularly on a price basis is able to extract a return based on the tendency of commodities to revert to their mean prices. Historical data confirm that a price-rebalanced index will tend to extract a return from “buying low” and “selling high” the uncorrelated commodities.
Robert Greer, senior vice president and portfolio manager for the PIMCO Real Return Fund, estimates that according to historical data, a commodities index can earn a rebalancing yield of approximately 2.5% on a long-term basis. The frequency of rebalancing is of particular importance, as data has shown that indices that rebalance more frequently are able to extract a greater return than those that rebalance less frequently.
Roll Yield: In addition to these two sources of return, a long-only commodity index will have gains associated with the change in price of the underlying commodities and the futures contracts on those commodities. For example, as a contract nears expiration, it will be “rolled over” to purchase new contracts on the commodity. At the time the position rolled over, there will be a gain or a loss depending on whether the underlying commodity has risen or declined in value. This portion of return is known as the “roll yield,” and will depend in large part on whether the underlying commodities are increasing or decreasing in value as well as the allocations of various commodities in the index.
Risk Premium: Finally, participants in the futures market can earn an insurance (or risk) premium since the long position is absorbing price risk that commodity producers, who are natural sellers, do not want. There may often be an imbalance between those wanting to sell futures contracts (like a farmer) and those willing to purchase futures contracts (such as a cereal manufacturer). The consumer (buyer of commodities) has less price risk than the producer because the end user can raise prices on the final product.
Investors in the futures markets serve to balance the market demand and in return, they are compensated for providing liquidity and assuming price risk.18 As a result, the investor is able to extract a return and profit from participation in the market and achieve an inherent positive return, or a compensation for the risk assumed by the investor. This component of return is closely related to the gain or loss on the underlying futures contract discussed previously.
An investor purchasing a futures contract and holding it to expiration will capture some risk premium in the marketplace and will also have a gain or loss depending on where the price settles at maturity. While these components of return are shown separately, they are closely linked and in some cases indistinguishable.
In evaluating the sources of long-only commodity index returns, we believe it is important to focus on those sources that relate specifically to an investment in commodities. As figure 1 shows, the key sources of return for a long-only commodity index are the gain or loss on the underlying futures contracts, the rebalancing yield, and a risk premium for providing liquidity to the market. The yield on the underlying cash position may or may not be considered as a source of returns to the index, although returns of the major indices include these in their total return calculations.
In the final analysis, the two main sources of return that relate directly to commodities are the gains and losses on the underlying futures contracts and the return that will come from providing liquidity to the markets due to the nature of futures contracts and the commodities markets. When analyzing long-only commodity index returns, it is important to focus on those sources that are related to commodities rather than those that are exogenous to the actual changes in prices of the futures contracts.
Investors who consider an allocation to commodities should also recognize the potential volatility of returns for long-only indices. In 1998, for example, the GSCI declined by 35%, a substantial one-year loss that was driven in large part by difficulties in the emerging markets. While this is comparable to the 30% decline in the Russell 2000 Growth Index during 2002, commodities do not provide the same long-term upside as small cap equities, with the key exception being energy related commodities, which have provided higher real returns. The longer-term standard deviation of the GSCI is close to 20% and, while this index has shown strong gains, the impact of the oil crisis of the 1970s heavily influenced the returns of this index. For example, from January 1970 through January 1980, the GSCI increased at an annualized rate of 21.8%, in large part due to the steep rise in oil prices during this time period.
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