Commodity ETFs/ETPs: The 3 sources of return

Investors buying commodity exchange-traded funds naturally focus on the prices of the ETFs/ETPs underlying commodities.

But it's important to remember that most ETFs/ETPs don't invest in commodities directly (though some precious metals ETFs/ETPs do). Instead, they buy commodity futures contracts that have 3 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 2 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 expiration date of the next futures contract—up to 3 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. So those wanting to hold a long position in futures over time 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 expiration 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 typically 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). In this case, 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-expiration 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 2 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 indexes include this source of return.

Of the 3 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 3 sources of yield and to recognize that only total return commodity indices include all 3, 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 information on the type of index it tracks.

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Article copyright 2014-2024 by Reprinted with permission from The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses.

Commodity ETPs are generally more volatile than broad-based ETFs and can be affected by increased volatility of commodities prices or indexes, as well as by changes in supply and demand relationships, interest rates, monetary and other governmental policies, or factors affecting a particular sector or commodity. ETPs that track a single sector or commodity may exhibit even greater volatility. Commodity ETPs that use futures, options, or other derivative instruments may involve still greater risk, and performance can deviate significantly from the spot price performance of the referenced commodity, particularly over longer holding periods.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.