Differences In Managing Contract Duration For Commodity Funds

There is an interesting BusinessWeek article that is worth the read if you invest, or are planning to invest, in a commodity fund. Since most commodity funds invest directly in futures, how those funds are managed can have an effect on returns.

One area of difference is how the fund manages margin. Since the fund is purchasing futures, margin must be set aside, but it is up to the fund to determine how those funds are invested. Some of the more conservative funds will purchase Treasuries, while others will invest in higher yielding bonds. Over the long haul this can have a noticeable effect on overall returns (and risk) for the fund.

Another area of difference which may have an even bigger impact is the effect of "roll yield." Roll yield is the positive or negative return you get when you sell one futures contract and/or roll an expiring contract into a new one. How often this is performed depends on both the duration of the contracts (how often they have to be rolled over), and any strategy employed by the commodity fund to try and manage the duration exposure. Depending on duration and strategy, having prices go into either contango and backwardation can have either a positive or negative effect on the commodity portfolio.

Some funds will only invest in short duration futures, essentially trying to mimic the commodity spot prices as close as possible. Other managers believe the fund is a long-term investment, and should be managed as such. These funds will buy contracts with durations from 3 months to 3 years. Various strategies and back-testing are performed to find the best contract durations based on whether the market is in contango (longer-duration contract prices are higher) or backwardation (longer-duration contract prices are lower).

Initial results are somewhat inconclusive as to which strategy is the best - i.e., managing the duration works sometimes, and sometimes it does not, especially if the dynamics of the market have recently changed. This is especially true of crude oil futures which seem to be affected on a daily basis by new variables in somewhat unpredictable ways.

Nonetheless, when purchasing a commodity fund it is worth thinking about what type of management you are comfortable with. Do you want relatively passive management with a fund that mimics the spot price dynamics - both good and bad? Or do you want a fund that tries to more actively manage the contract durations, allowing the fund to respond better when the market is either in contango or backwardation - even if fundamental and technical changes can put the fund on the wrong side of the market? As usual, it is often a matter of personal preference and current exposure. Unfortunately, while investing in commodity funds is certainly easier than trading futures for most, you still need to do your homework.