Understanding the Components of Commodity Futures Returns

Investing in commodity futures offers a unique way to diversify portfolios and capitalize on price movements in resources such as oil, metals or agricultural products. However, the returns from commodity futures are influenced by more than just the price of the underlying commodity. There are three key components to consider: spot price, roll yield and collateral return. Understanding these elements is crucial for investors seeking to optimize their strategies in the commodities market.

Spot Price: The Foundation of Futures Returns

The spot price is the current market price at which a particular commodity can be bought or sold for immediate delivery. In the context of commodity futures, the spot price plays a central role as it represents the actual market value of the underlying asset at a given time.

Changes in the spot price directly impact the value of a futures contract. For example, if you hold a futures contract for oil and the spot price of oil rises, the value of your contract typically increases as well, assuming other factors remain constant. Thus, the spot price is the most straightforward component of commodity futures returns—when the spot price rises, so do the returns on the futures contract.

Roll Yield: The Impact of Contango and Backwardation

Roll yield is a more complex but crucial concept for understanding the total return from a futures investment. Roll yield arises from the practice of "rolling" futures contracts—replacing an expiring contract with a new one to maintain exposure to the commodity.

Futures contracts have expiration dates, and as they approach expiry, investors often sell their positions in the expiring contract and purchase new contracts further out on the curve. The difference in price between the expiring contract and the new one determines the roll yield.

• Contango: When the futures curve is in contango, the prices of longer-dated futures contracts are higher than those of near-term contracts. In this situation, rolling into a new contract usually results in a negative roll yield, as investors must pay more to purchase the new contract than they receive from selling the expiring one.
• Backwardation: Conversely, when the futures curve is in backwardation, longer-dated contracts are cheaper than near-term ones. This scenario typically results in a positive roll yield, as investors can sell the expiring contract at a higher price and buy the new one at a lower price.

The state of the futures curve—whether in contango or backwardation—can significantly influence the overall returns of a commodity futures investment. In markets that are consistently in backwardation, the positive roll yield can enhance returns, while in markets in contango, the negative roll yield can erode potential profits.

Collateral Return: The Interest on Cash Reserves

Collateral return, or collateral yield, is the third component of futures returns. It refers to the interest earned on the cash or cash-equivalent assets held to collateralize a futures position. Since futures contracts typically require only a portion of the contract value to be posted as margin, the remaining funds can be invested in short-term, risk-free instruments, such as Treasury bills.

The return from these investments, known as collateral return, may not be as significant as the spot price or roll yield, but it still contributes to the overall return on a futures investment. For institutional investors managing large portfolios, even small differences in collateral returns can add up over time, making this a non-negligible factor in futures investing.

Why These Components Matter

Understanding these three components—spot price, roll yield, and collateral return—is essential for anyone investing in commodity futures. Together, they determine the total return on a futures investment, and each plays a unique role. Consider 2022...

2022 was marked by disruptions in global energy supply and a dramatic rise in global interest rates—both of which significantly impacted commodity futures returns. Russia’s invasion of Ukraine in late February and the U.S. Federal Reserve’s aggressive stance to combat rising inflation in the U.S. led to significant gains in both the price of energy-related commodities and yields on U.S. Treasuries. While the prices of many energy commodities eventually fell from their early-to-mid-year peaks, the futures curves of nearly all energy commodities remained in extreme backwardation for the remainder of 2022. Consequently, roll yields—as well as the nearly 4.75% yield earned on most short-term U.S. Treasuries by year-end—were significant contributors to commodity returns beyond just spot price movements.

For both individual and institutional investors, understanding these components allows for more informed decision-making and better risk management. By carefully analyzing the interplay between spot prices, roll yield and collateral returns, investors can craft strategies that align with their risk tolerance and investment objectives, ultimately optimizing their outcomes in the commodities market.

Why Consider the “Constant Maturity” Approach?

VanEck CM Commodity Index Fund and VanEck CMCI Commodity Strategy ETF – VanEck’s passively managed strategies that track the UBS Constant Maturity Commodity Index (CMCITR) – offer truly diversified commodity exposure—including exposure across each of the major commodities sectors (energy, agriculture, industrial metals, precious metals and livestock), as well across maturities for each individual commodity (ranging from one month to three years, effectively spreading exposure to each commodity component along the futures curve).

With CMCITR, the maturity of each commodity component remains fixed at a predefined time interval from the current date. The “constant maturity” concept is achieved by a continuous rolling process, where a weighted percentage of contracts are swapped for longer-dated contracts daily. This procedure produces a more continuous form of “pure” commodity exposure and provides a better balance of forward price behavior than traditional commodity indices. Additionally, this feature of CMCITR can minimize exposure to the negative effects of roll yield, making the index more representative of the underlying market price movements.

To understand more about how this approach works, check out Investing in Commodities Intelligently: Question and Answer.

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