Articles

Commodities In A Portfolio
By Sal Gilbertie

Page 2 of 6

Benchmark Design And The Futures Curve: Contango And Backwardation
When first developed and introduced in the 1990s, multicommodity indexes/funds became popular (and remain so today). This is due mainly to their ability to give nonfutures investors direct exposure to commodities through indirect futures holdings via an index or fund.

These funds are sometimes referred to as "first generation" funds due to their concentration of holdings in the very front of the futures curve. This is because their focus is generally more on achieving direct exposure to the commodities and less on how efficiently the benchmark might perform over time versus a given investor's time horizon and expectations.

These funds can be affected by issues unique to futures pricing called contango⁴ and backwardation,⁵ which can have unpredictable effects on investor returns over time. Contango and backwardation are generally more of a concern in the energy, agricultural and industrial metals sectors than they are in precious metals. The latter category has minimal storage and carrying charge costs associated with it compared with other commodities, where storage, processing, spoilage and other costs affecting contango and backwardation can be substantial.

As the issues of contango and backwardation have come to the fore of the collective thinking of the investor community in first-generation funds, a number of "next generation" funds and ETP products have been introduced. These ETPs have benchmark holdings or trading methodologies specifically designed to mitigate (as much as possible) the potential effects of contango and backwardation. However, bear in mind the fact that contango and backwardation can never be fully eliminated. Both are a fundamental element of commodities trading and are an important factor when choosing a commodities-based ETP design that is right for one's needs.

Generally speaking, investors and asset allocators who want to add beta to their portfolio using commodities will be buying and holding their selected commodities exposure long term. This means that a next-generation commodities ETP, designed to mitigate contango and backwardation, may be a more appropriate choice than a (possibly more widely recognized) first-generation ETP. Conversely, an investor looking at shorter-term exposure to a commodities sector (or sectors) may be better served by a first-generation ETP. Your investment's time horizon is particularly important when implementing beta optimization (alpha) strategies through ETPs.

Any combination of ETP choices can be effective, but in all cases, the benchmark design and holdings of the ETP are what will drive returns more than any other factor.