2008 was a year of extremes for the commodities market. The most important commodity in the world economy, oil, rose to a historic high of US$147 per barrel in July, before collapsing in price to around $40 per barrel by year-end. Other raw material prices had a similar roller-coaster ride, although there were substantial divergences in returns between the different commodity sectors. While commodities performed, on aggregate, slightly better than equities over the year, the synchronous price collapse of both from September onwards will have caused many investors to question whether commodities' often-advertised diversification properties exist at all.

Divergence by Commodity Class

The five main sub-indices of the Dow-Jones AIG commodity index gave returns for the year ranging from -4% for the precious metals sub-index to -47% for the energy sub-index. The 2008 returns for the sub-indices, together with the 3,5, and 10 year cumulative returns, ten-year correlations with the DJ Euro Stoxx index, and ten-year annualised daily volatilities, are shown in the table below (data are reproduced from the ETF Securities 2008 Commodities Review). All return figures are in US Dollars.

For all the commodities categories except industrial and precious metals, 2008's declines have effectively wiped out any positive returns on a five-year view. Over ten years, there is a big divergence between the returns from the energy and metals sectors, which have given investors handsome returns, and those from the agriculture and livestock sectors, which have not.

Correlations with equities have been highest for industrial metals (as one might expect, given the direct linkage to economic production), whereas precious metals have shown themselves to be uncorrelated—a big plus for portfolio investors, who spend a great deal of time searching for assets with similar characteristics. This, when combined with the relatively strong returns gold (in particular) has achieved over the last year, explains why investor inflows into this commodity continue to surge.

Spot, Near Term Or Forward?

One complication that a commodity investor runs into immediately is the question of backwardation and contango.  In the first case (backwardation), longer-dated commodity futures contracts trade at a lower price than the spot price, meaning that an investor who rolls his commodity futures position from one contract to the next gets to reinvest at a lower price each time, earning a positive roll yield. In contango, forward prices are higher than spot, eating into investors' returns when they roll from one contract to the next.

In order to avoid the negative roll yield associated with commodities trading in contango, some ETF providers offer diversified commodity indices that do not follow a simple rule of tracking the nearest-term futures contract (more on this below). ETF Securities, via its forward ETCs, also offers investors the chance to avoid the traditional rolling of near-term futures contracts and to track contracts 3 months forward from spot. The dramatic difference resulting historically from a change in "roll policy" is visible in the table below, which shows the contrasting returns from the different AIGCI sub-indices and their "forward" counterparts. The precious metals sub-index is excluded, since for these commodities there is typically little difference in the returns achieved by rolling futures contracts as opposed to investing in the metals directly at the spot price.

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