Investors buying commodity exchange-traded funds naturally focus on the prices of the commodities themselves.
But it's important to remember that most ETFs don't invest in commodities directly (though some precious metals ETFs do). Instead, they buy commodity futures contracts that have three sources of return.
The return on a commodity futures contract is the sum of:
Change in spot price + roll yield + collateral yield
Excess return indices include the first two types of return, but only total return commodity indices include the third source (collateral yield).
The spot price of a commodity is the price quoted for immediate or short-term delivery, and implies a direct investment in the physical commodity. In practice, "spot" delivery can be as far out in time as the expiry date of the next futures contract—up to three months forward.
In practice, few investors or traders in commodities have the ability to take physical delivery of raw materials, something that could incur significant storage and insurance costs. Those wishing to hold a long position in futures over time therefore have to sell ("close out") positions in expiring futures contracts and reinvest their money into longer-term contracts.
But the prices of commodity futures contracts with longer-term expiry dates are usually quite different from the price of the nearest-term contract.
When a futures market is in contango, the price of the commodity for future delivery is higher than the spot price (longer-dated futures prices are higher than near-dated futures). A chart plotting the price of futures contracts over time is upward-sloping.
When a futures market is in backwardation, the opposite occurs (far-dated futures are lower than the spot or near-term futures price). A chart plotting the price of futures contracts over time is downward-sloping.
To recap, an investor buying a commodity futures tracker must reinvest continually from expiring nearer-dated contracts into further-from-expiry longer-dated contracts.
When the market is in contango, this means selling out of futures at lower prices and reinvesting at higher prices, a policy that generates a negative roll yield.
When the commodity market is in backwardation, a futures investor earns a positive roll yield by selling out of expiring contracts at higher prices and reinvesting at lower prices.
The expected changes in a commodity's spot price and the roll yield earned by the investor in a commodity tracker should be seen as two sides of the same coin. This is because contango (an upward-sloping curve of futures prices over time) implies an expectation of rising spot prices (after adjusting for the cost of storage).
In other words, some of the money you will lose as a result of the negative roll yield incurred by the index of a commodity that's in contango may well be offset by rising spot prices.
Backwardation (when spot prices exceed future prices) generates a positive roll yield, but is typical for commodities whose spot prices are expected to fall over time.
The third component of a commodity futures investor's return—collateral yield—arises because investors in commodity futures must set aside collateral. This collateral generates interest income, which is then reflected in the futures price. Only total return indices include this source of return.
Of the three sources of excess return to a commodity futures investor, changes in spot prices and the roll yield are the most important. The relative importance of the components can change over time, too.
In the 1970s, investors in commodities earned money from rising spot prices and also from positive roll yields, as many commodity contracts remained in backwardation. But in the 2000s, commodity markets traded in contango for much of the time, meaning investors' gains from rising spot prices were offset to some extent by negative roll yields.
In sum, it's advisable for potential commodity investors to understand all three sources of yield and to recognize that only total return commodity indices include all three, while excess return indices only include the return from the change in spot and the yield from rolling futures contracts. Check your fund's prospectus for more information on the type of index it tracks – it’ll be clear from the stated investment objective.