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Are commodity ETFs bad for managed futures?
March 29, 2010
The investment manager of a pension fund which invests in managed futures through Attain posed a great question the other day, asking: “With the rush of capital into commodity futures from ETFs, the presence of contango in most commodities and the issues those ETFs are having tracking spot commodity prices, what is the effect on returns for managed futures programs?”
What a loaded question! I’m sure there are 500 page doctorates being written on the commodity ETF/ contango/ spot price issue at some prestigious university right now. We considered telling him it was impossible or that it would take 2 months of research at best, but of course welcomed the challenge in the end, saying we’ll give it a shot (but in our newsletter, and shared with all of our clients).
What exactly is the ETF/Contango/Spot Price issue?
The first place we should start is explaining the terms in this question. First, we have the commodity ETFs, or Exchange Traded Funds. Most investors are familiar with ETFs by now, and they are pools of investor money (like a mutual fund) which trade like stocks on an exchange (unlike a mutual fund). Commodity ETFs are a special type of ETF which buy futures contracts on various commodities in an attempt to track the price increase in those commodities. They are called ETPs in Europe, for Exchange Traded Product, but are essentially the same thing. Examples include USO, UNG, GLD, and UCO.
With the massive run up in commodities from 2003 to 2008 (Copper+413%. Crude Oil +191%, Wheat +314%, for example); investment firms have been tripping over themselves ever since then to launch funds which track commodity prices in hopes of catching similar returns when and if there is a next commodity bull run. The funds flowing into these commodity ETFs have been massive. Assets in ETFs increased 130% in 2009 from $13.4 Billion to $30.9 Billion (WSJ), while European ETPs saw a 145% increase up to 21.2 Billion Euros (FT.com).
So what’s the problem? Well, it appears these funds don’t do that well at actually tracking the commodities they are supposed to track because of a phenomenon called contango in most commodity markets they track.
Contango is little more than a fancy word for explaining a futures contract curve where the further out contract months are more expensive than the front month contract months. It’s easier to understand using an example. Take Crude Oil futures. If the contract for January delivery is at $60, February delivery at $62.50, March delivery at $65,…..and December delivery at $75 – the further out the delivery, the more expensive the contract value. This is known as Contango, and reflects a view that future prices will be higher than current prices. Assuming a growing population, growing economies, and limited supply of commodities, there is research which shows the natural state for commodity pricing is contango. The opposite, when current prices are more expensive than future prices, is called backwardation. That can occur when there is a supply issue such as when Hurricane Katrina shut in all of the Gulf of Mexico oil production.
Why does contango pose an issue for commodity ETFs? Because these ETFs buy the nearer month futures contracts so that their share price tracks what is going on in the most actively traded contract, and must roll their positions to the further out months when the contracts expire (remember that a futures contract has a finite lifespan, with the February 2010 contract ceasing to exist on January 22nd, 2010; for example). The difference between the nearer month price and further out month price when they roll is called the roll yield. In a contango market, the roll yield is negative because the roll results in selling the cheaper contract and buying the more expensive one. In our example above, if rolling from February to March Crude Oil futures, you would sell the Feb at $62.50, and buy the March at $65, resulting in a negative roll yield of -$2.50.
How big of a deal is this roll yield? Steve Johnson of the Financial Times wrote in his 3/21/2010 article Alarm over commodity ETP returns: “The effect of this roll yield can be huge; while the benchmark S&P GSCI spot index has returned 69.3 per cent since the start of 2005, the equivalent total return index, which factors in the roll yield, has produced a loss of 15.6 per cent.”
One only need look at the chart comparing the cumulative gain in Crude Oil spot prices against the gain in the USO (Oil tracking ETF) to understand:
The spot price of a commodity is the price for a one-time open market transaction for immediate delivery of a specific quantity of product at a specific location where the commodity is purchased "on the spot" at current market rates according to the US Energy Information website. In layman’s terms, it is the current market price. In theory, a futures contract’s price should equal the spot price on the day of expiration, as the issuer of the contract must purchase the commodity at the spot market price to deliver to the holder of the futures contract on expiration.
As can be seen in the table above, the USO Oil tracking ETF has done anything but track along with the gain in the spot price of oil over the past 16 months. While spot prices have risen nearly 80%, the USO Oil tracking ETF has barely made over 5%. This huge difference is the result of the USO having to roll their positions every month from the futures contract set to expire that month to the one which will expire the following month. With Crude Oil futures having contracts for all 12 months, the situation is exacerbated for the USO even more so than other commodity ETFs, as they pay the negative roll yield 12 times per year.
What does this mean for managed futures investments?
It seems logical that if managed futures programs generally try and catch and ride trends in commodity market using futures contracts, and that if there is contango in the futures market they are trying to capture the trend in (such as Crude Oil)… that managed futures would be susceptible to the same negative roll yield and spot vs roll issue that commodity ETFs are; but is that really the case?
Let us first say that it is definitely not the case when the managed futures program you are investing in has an average trade hold time of less than 30 days. If they aren’t holding a trade more than 30 days on average, they aren’t doing rolls (or doing 1 at most), so the roll yield doesn’t apply at all. It also doesn’t apply to option selling programs, which even if they did roll their options (which they don’t) are always selling them (thus earning the roll yield). There is always contango in options, as well, where the time value of further out options makes the further out more expensive. It also doesn’t apply (in the way we’ve talked about above) to programs which do spread trading between contract months. They are actually betting on a market moving from contango to backwardation, or becoming more or less contango than it already is.
So, right off the bat – we can say that roughly 1/3 of managed futures programs can’t, by definition, be affected by a negative roll yield.
To more accurately revisit our question then, does contango and the roll yield present a problem for managed futures programs which trade multiple markets and can hold a trade across multiple rolls? We put this question to dozens of managed futures advisors we work with, and got quite a response from them, which you can read below. But the general feeling amongst them was no, this isn’t a problem for their programs or managed futures investors in general.
You can read each manager’s comments by clicking here (there’s quotes from: III, TYL, Global Advisors (Jersey), 2100 Xenon, Mesirow, Covenant, Accella, Robinson Langley, DMH, and Dominion), but we’ll summarize by saying the reason the roll yield isn’t a factor for managed futures programs is because 1. it is built into their models and 2. they are not the passive long only investment a commodity ETF is (making an ETFs trade duration essentially infinite).
Simply put – managed futures programs are not trying to catch the same trends that are happening in the spot market, and they aren’t always buying. They are trying to catch futures market trends both up and down.
This may seem like splitting hairs, but for the negative roll yield to pose a problem to managed futures programs, those programs would have to be using spot prices as their data input, and then initiating long positions in the futures markets based on the upward movement in spot prices. That mismatch, using the data of one market, but executing in another – is what causes the roll yield issue, but most managed futures programs are not even looking at the spot price data.
It is easier for brokers and commodity trading advisors to sell their programs by saying they attempt to capture the trends in commodity markets, and in a very general sense that is what they attempt to do. But the devil is in the details, as always – and the truth is they are not trying to catch trends in commodity spot prices. Rather, they are analyzing the futures price data to signal trades, and in so doing are using roll adjusted prices. By patching the different contracts together into a continuous price series by adjusting the previous prices by the roll yield at each roll period, managers are essentially building the roll yield into their models. This process is called backadjusting.
As proof of this, consider that the backadjusted Crude Oil futures contract was only up $8 from Dec. 15th, 2008 through March 15th, 2010. As can be seen below, that is nearly identical to the gain seen when rolling the futures every month to the next contract on the 15th of every month (1 mo roll); while the spot price was up $35 over the same period. It’s as if the backadjusted contract “knows” the spot price is unattainable, and is using the attainable roll adjusted prices instead to consider whether there is a trend going on.
Looking back at it now, this ability of contango to “erase” a trend when looking at the market on a roll adjusted basis was one of the problems for managed futures in 2009 – as the contango in many markets was at all time highs towards the end of 2008 (it has since come down to more normal levels). Many of you have probably asked why your managed futures program didn’t catch the trend in this market or that – and one of the reasons is that it didn’t appear to be a trend to the logic of the manager’s trading model. The larger the contango, the more the roll adjusted prices look less trendy than the spot market prices appear.
Does the spot price matter?
Now, seeing that ETFs have trouble tracking spot prices because they use futures to do so, and that managed futures programs don’t track spot prices by design - we ask the question of whether it really matters? Is tracking the spot price even realistic or attainable?
I can’t believe we’re doing this, but we’ll defend the ETFs for a second. (we generally don’t like them in the futures industry, because whereas we are required to have customers read through pages upon pages of disclaimers about how much money they can lose – an investor can own a commodity ETF in his or her stock account through a few clicks on his iphone; without even knowing what a futures contract is, without having to read disclaimers, and without signing disclosure documents.)
We’ll defend the ETFs by noting that the graph and numbers above, and all of the articles we’ve read out there mentioning how ETFs don’t track the spot price ignore one big component of commodity returns. That component is the cost of carry. Oil tankers, grain elevators, and warehouses all cost money. Likewise, insurance costs money, and financing costs money (at least it used to). All of these costs to own a commodity are called the ‘cost of carry’, and any calculation of gains on the spot price alone ignore the fact that you can’t just buy a commodity for one price and sell it for another price at some point in the future. You have to pay money to store it, transport it, insure against it rotting/burning/being stolen, and in some cases borrow money to purchase it.
When considering the cost of carry, the returns of the spot price are drastically reduced. In Crude Oil, for example, the cost of carry for a non producer can be around $1 per barrel per month (source). When considering that cost and calculating the spot price minus cost of carry price appreciation over the past 16 months for Crude Oil, the 12/15/08 to 3/15/10 gain in Crude prices is only 38% (versus 78% without the costs).
This should make it clear that the pure spot price appreciation isn’t a fair comparison for ETFs, and they should instead be judged against the spot price minus the cost of carry. Problem is, they still underperformed the spot price minus the cost of carry by a count of 5.40% to 38% over our test period…so we’ll stop defending them now.
In the end, commodity ETFs are essentially mis-marketed (some would say criminally so). They are not designed to track the spot price – nor can they even come close because of the cost of carry. They are designed to track the performance of front month futures contracts on that commodity market rolled over at each expiration. The fact that so much money has flowed into these investments tells me that investors either aren’t being told or don’t understand the difference.
Why don’t the ETFs just buy further out contract months (say 6 to 12 months) and roll those every 6 to 12 months? Great question. As can be seen below, that would save their investors a lot of money and get them a lot closer to the spot price (minus cost of carry). We calculated what the return would be when rolling Crude Oil futures every 1 month, 3 months, 6 months, and 12 months on the 15th of each month across the period 12/15/08 to 3/15/10; and compared them to the cost of carry adjusted spot price (using $1/bl/mo cost) and USO performance.
You can see that the USO and the 1 mo roll are nearly identical, while the longer hold times and roll periods see performance closer to the cost adjusted spot price. If you’re invested in one of these ETFs, call them today and tell them you want a longer hold time and less rolls.
Opportunity Cost for Managed Futures?
The chart above got us thinking that perhaps the negative roll yield could cause an issue for managed futures in a under the radar sort of way, by keeping managed futures programs from participating in trends which occur on data sets looking at different roll periods. Perhaps there is an opportunity cost related to using 1 month roll adjusted data for managed futures price signals. Would you rather be trading the 6 month roll adjusted curve or the 1 month roll adjusted curve in the chart above? I’m sure the answer is the 6 month roll, which performs nearly 40 times better.
If contango and super contango become the norm for many markets, perhaps we’ll see managed futures programs adapt (that’s the beauty of active management, they can adapt and react to situations, and aren’t at the mercy of the market dynamics) by experimenting with different roll periods for their backadjusted data. That may just open up trends for them which the 1 month roll crowd (the ETFs) aren’t seeing. I know we’ll be putting it on our research task list at Attain Portfolio Advisors.
The only question we’ve left unanswered is the question of what does all of this money coming into the futures markets via commodity ETFs do to the underlying fundamentals of those markets. Wheat, for example, hasn’t converged with its spot price upon expiration for many, many months; and those types of dislocations can cause problems for fundamental traders who rely on futures prices reflecting what is going on in the cash market. Systematic managed futrues programs, on the other hand, shouldn’t much care about such dislocations – as they aren’t thinking where prices ‘should be’ in their models, and instead are reacting to where prices have been.
As we can see, there are a lot of issues with the commodity ETFs which track front month futures contract prices, especially when everyone incorrectly wants to compare them to spot prices and ignore any costs.
We don’t believe these issues will affect managed futures programs in the same way because 1. Not all managed futures programs are holding positions which require periodic rolling of the contracts 2. managed futures programs aren’t always long as the ETFs are, 3. managed futures programs use roll adjusted data in their models which considers the negative (or positive) roll yield, and 4. managed futures programs don’t imply they will track the spot price of the underlying commodity.
Whether the incredible inflow of capital continues into these ETFs given their inability to track spot prices (whether that’s a fair comparison or not) remains to be seen. But managed futures, on the whole, should not be negatively affected if they do. To the contrary, managed futures may even see increased assets under management as some disenchanted commodity ETF investors consider the benefits of actively managed commodity portfolios.
PS – Please be sure to view the comments on this topic from managed futures advisors we work with by clicking here (there’s quotes from: III, TYL, Global Advisors (Jersey), 2100 Xenon, Mesirow, Covenant, Accella, Robinson Langley, DMH, and Dominion).
Disclaimer: Past performance is not necessarily indicative of future results. The data and graphs above are general market data from Attain data providers. They are intended to be mere examples and exhibits of the educational topic discussed above, are for educational and illustrative purposes only, and do not represent trading in actual accounts.
IMPORTANT RISK DISCLOSURE
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Overall market action in most sectors was fixed in a mixed to choppy state during the past week, although a late EU/IMF agreement about Greek sovereign debt and another week of constructive U.S. economic reports helped support price activity in the stock index sector. The firm tone was led by the Russell 2000 futures +1.41% and followed by Dow futures +1.04%, NASDAQ futures +1.01%, S&P500 futures +0.62% and Mid-Cap 400 futures +0.43%.
Indications that the Chinese government would stick by their word of not aggressively pursuing more cash gold in the foreseeable future kept a lid on most metal contracts during the past week. Palladium -2.82% led the declines followed by Platinum -0.78%, Silver -0.74% and Gold -0.30%. Copper +0.90% defied the rest of the complex on ideas of heavier industrial use in the futures if economic growth can be sustained not only in the U.S., but abroad.
News that EU membership and the IMF would come to the aid of Greece if their sovereign debt issue imploded into a default did not seem to aid continental currencies during the past week. The marketplace seemed to take a wait and see approach with the late week agreement after several earlier attempt fell by the wayside. The U.S. Dollar index +1.24% benefitted from the uncertainty. Japanese Yen -2.15% led the balance of the complex lower followed by the Euro -0.89%, British Pound -0.75% and Swiss Franc -0.39%.
Commodity and Food products were again mixed last week as fundamental factors ruled price activity in most cases. Corn -4.86% and Wheat -3.93% were pressured by burdensome world supplies as Soybeans -1.00% followed along. Livestock activity was weak with Lean Hogs -5.51% on growing product supplies and Live Cattle -3.73% on ideas that cash market may have seen its peak with the improvement in the weather. Soft sector price action was mixed with Sugar -8.80%, OJ -6.42% and Cotton -3.03% hampered by ideas of better crop prospects due to improving worldwide weather. Coffee +2.53% and Cocoa +0.71% ended higher on improvement from the demand sector.
After a choppy start to the month, many Option Trading managers have found the slowdown in volatility across the board to their liking. In particular, the diversified trading of Financial Commodity Investments (FCI) has successfully turned a down month into a potential positive (3 trading days to go) with current estimated gains of +1.23% in the CPP program and + 0.93% in the OSS program. One place Option Trading has struggled is in the single market (Live Cattle) trading of Oak Investment Group where the program is down in the range of -31% for the month. Oak had been on a hot streak over the past 12 months returning an estimated 68.66% and will be watching this week’s cattle expiration very closely for an opportunity to recover some of the open trade losses.
Other option trading estimates are as follows: ACE SIPC -0.57%, ACE DCP +1.20%, Cervino Diversified Options +0.14%, Cervino Diversified 2x +0.21%, Crescent Bay PSI -0.51%, Crescent Bay BVP +1.89%, and HB Capital +0.43%.
Specialty market managers are beginning to show some signs of life after several months of flat performance. Leading the way thus far has been Agriculture Specialist Rosetta Capital Management with an estimated gain of +4.72%. Rosetta has been stuck in drawdown since their last equity high in March 2008 where market fundamentals simply stopped working…we’re optimistic that a turn around by Rosetta could be a sign of a shift in the market back toward fundamental price action. Other Specialty manager estimates are as follows: Emil Van Essen Low Minimum +1.14%, NDX Abednego -0.64%, NDX Shadrach -0.37%, and 2100 Xenon Fixed Income -0.61%.
Last week was a good week of trading for multi-market managers as most posted gains for the week. Monthly performance remains mixed however, as approximately 50% of the managers we track are currently in the black for March. Leading the way is a brand new program at Attain, Applied Capital Capital Systems at +2.33%. ACS has had recent success trading foreign exchange along with foreign treasury markets. We congratulate them on their fantastic start.
Other managers that have had a nice month of March include Dominion Capital Management Sapphire +1.83%, Accela Capital Management Global Diversified +1.32%, 2100 Xenon Managed Futures (2x) +1.11%, Integrated Managed Futures Global Concentrated +0.64% and APA Modified Program +0.52%. Mesirow Financial Commodities Absolute Return Program is at breakeven for the month, as is the Mesirow Financial Commodities Low Volatility Program.
Programs in the red include DMH -0.06%, APA Strategic Diversification -0.11%, Hoffman Asset -0.15%, Clarke Capital Worldwide -0.68%, Quantum Leap Capital -1.07%, Dighton Capital USA Aggressive Futures Program -1.09%, Robinson Langley -1.24%, Clarke Capital Global Magnum -2.21%, Futures Truth MS4 -2.58%, GT Capital -2.77%, Covenant Capital Aggressive -2.97%, Clark Capital Global Basic -3.49%, and Futures Truth SAM 101 -7.17%.
Short term trading performance is mixed as well with multi-market trader Sequential Capital Management posting gains of +2.14%, while ES trader Paskewitz Asset Management Contrarian 3X St. Index is down -12.18%.
Systems had a slow week of trading, as the markets remained calm for the majority of the week despite the FOMC meeting on Tuesday. Activity picked up a little bit on Friday as the markets sold off, however most systems chose not to trade. Of those that were active, the top performer was soybean swing trader MoneyBeans S +$1602.50 on 3 trades. Other profitable systems include BAM 90 +$585.0, Strategic SP +$475.00, AG Mechwarrior +$390.00, UpperHand ES +$277.50, and PSI! ERL +$220.00. Waugh CT ERL was at breakeven for the week.
Strategies that did not fare as well include Polaris ES -$42.50, Compass SP -$140.63, Clipper ERL -$440.00, MoneyMaker ES -$447.50, BAM 90 Single -$505.00, Strategic NQ -$570.00, and Strategic ES -$622.50.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.