Commodities are the epicenter of rising inflation.
When it comes to measures of inflation like the consumer price index (CPI), commodity prices are predictive…
For instance, if you see prices for energy rise over the course of a few weeks, you can pretty much bet the farm that the next CPI reading will show an uptick …
But investing in this asset class has a history of being inaccessible to regular investors…
Which is unfortunate since, as we pointed out earlier this week, it has been the best performing asset class of the year… and could be for quite some time.
When most people think of investing into commodities, they just think of energy… but there are always opportunities outside of energy that offer investors outsized returns.
I’ve been recommending broad-based commodity exposure since the beginning of the year… and today I’m going to discuss specifically what really drives commodity prices and how regular investors can profit from it.
Staying Ahead of Inflation
Even though commodities as an asset class may seem fragmented, there is one single, overarching factor that unifies them all…
Tracking this factor provides regular investors with a simple, easily accessible framework to profit from this trend, which I believe will last longer than our policymakers at the Fed may think…
All of the supply chain disruptions, shortages, and price momentum in commodities can be distilled into this one measure…
And that factor is called the “roll yield,” which is defined as the amount of return available in the futures market after an investor “rolls” a short-term contract into a longer-term one.
But before I explain how this all works, the best way to illustrate its effects is to show it in a series of charts… because it’s really simpler than it seems.
Let’s take oil as an example…
The chart below shows oil prices (black line) from 2014-2019. This was a period when the oil market was well-supplied and short-term contracts traded below long-term contracts – or had negative roll yield. Right now, oil supplies are tight so they’re trading above it.
The red line represents oil prices adjusted for the roll yield and shows the effect of owning oil passively, either through ETFs or the futures market. Since many commodity ETFs own the underlying futures contracts, the same effect is seen in their returns as well.
You can see the stark contrast in returns…
Investors may have been stunned to learn that although oil prices fell 43%, they actually lost 67% by passively holding.
That’s the effect of negative roll yield… selling futures at a lower price and then rolling into higher-priced contracts that expire later.
On the other hand, take a look at soybean prices this year…
Its roll yield has been predominantly positive this year… and you can see the returns start to diverge in favor of passively holding soybeans.
That means when investors roll these contracts, they sell high and buy the next expiring contract at a lower price…
So, why does this happen?
Well, it boils down to the convenience of having readily available inventory.
Producers and users of commodities need to ensure that they have adequate supplies on hand to continue running their operations. That’s why this “roll yield” term is sometimes called a “convenience yield.”
And because they are much less concerned about the price of a commodity than having inventories on hand, they are willing to pay more for short-term contracts than long-term ones.
As long as those shorter-term contracts are trading higher than contracts that expire further out into the future,
prices will generally rise and continue their momentum.
That’s where the majority of returns in the commodity markets come from…
By only allocating to commodities that display positive or rising roll yield, investors can stay ahead of inflation and sidestep any commodity that’s about to take a nosedive.
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Don’t Fear the Reaper
Right now, there are two ETFs that do their hardest to give investors access to roll yields… but ultimately fall short. I believe investors that do a little extra homework or have access to research that tracks roll yield dynamics can significantly outperform these ETFs.
But for what’s out there, the Invesco Optimum Yield ETF (PDBC) and the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT) offer the best type of exposure for investors because they dynamically allocate into commodity futures with positive roll yield.
You can see this in the returns of 31% for PDBC and 28% for COMT year-to-date… The Bloomberg Commodity Spot Index rose only 21% during the same time. That outperformance is coming from the roll yield… but it should be much greater than that.
Even though they are the biggest ETFs with $6 billion and $2.6 billion under management, respectively, with institutional investors making up over 85% of total ownership of both products – they are flawed.
The problem with these ETFs is that they’re not dynamic enough and their commodity exposure isn’t pure.
They’re paired with a slew of fixed income products… and not just run-of-the-mill Treasury bills and notes, which are akin to cash, but bonds from corporations – both U.S. based and abroad.
So even though they provide commodity exposure, there is also inherent credit and duration (level of sensitivity to interest rates) risk involved.
However, these ETFs are just a start… Investors who want to boost their portfolios and hedge against inflation should become familiar with roll yields as supplies tighten and the term rapidly approaches the mainstream.
Contributing Editor, Market Minute
How do you invest in commodities? Will you be trading those ETFs or take a different approach?
Let us know any comments – or questions you may have – at [email protected].