Return Characteristics of Commodities: What to Actually Expect

Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010

The Big Promises

Chapter 16, written by Dianna Preece, examines what returns you can actually expect from commodity investments. Before the financial crisis of 2007-2008, the pitch for commodities was compelling: equity-like returns, inflation protection, and negative correlation with stocks and bonds. Three benefits wrapped into one asset class. Sounds almost too good to be true.

And, as it turns out, the reality is more complicated than that sales pitch.

Three Sources of Return

When you invest in commodity futures, your return comes from three distinct sources. Understanding these is important because they behave very differently.

Collateral return is the simplest. Because futures contracts are leveraged, you do not pay the full value upfront. The cash you post as collateral can be invested in risk-free assets like Treasury bills. The return on that collateral is your collateral yield. Here is an important detail that gets overlooked: the collateral return is actually the real inflation hedge in commodities, not the commodity price itself. The T-bill yield adjusts with inflation, so your collateral tracks it automatically.

Spot return is the change in the underlying commodity price. Supply and demand drive this. Weather, geopolitics, economic growth, all of it feeds into spot prices. Over long periods, the historical average spot return has been roughly equal to the rate of inflation. Spot returns are volatile and can be positive or negative for extended stretches.

Roll return is unique to futures-based commodity investing. Because futures contracts expire, long-term investors must sell expiring contracts and buy longer-dated ones. The gain or loss from this rolling process is the roll return. Whether the roll return is positive or negative depends on whether the market is in backwardation or contango.

Backwardation vs. Contango: Why It Matters So Much

In backwardation, futures prices are below spot prices. When you roll your expiring contract into a cheaper longer-dated one, you are essentially buying low. As that new contract approaches expiration and converges to the higher spot price, you earn a positive roll yield.

In contango, futures prices are above spot prices. Rolling means selling your expiring contract and buying a more expensive longer-dated one. This creates a negative roll yield that eats into your returns.

A 2007 Vanguard report noted that the roll return appeared to be shrinking or even disappearing. If that is true, investors using historical commodity returns as a guide for the future might be in for disappointment.

The Academic Evidence: A Timeline

Preece walks through decades of research on commodity returns. The story changes over time.

Greer (1978) was one of the first to argue that commodities belong in conservative portfolios as an inflation hedge. Between 1960 and 1974, collateralized commodity futures outperformed equities and had a lower maximum drawdown.

Bodie and Rosansky (1980) looked at 23 commodities between 1950 and 1976. They found equity-like returns, similar volatility to the S&P 500, but with more positively skewed returns. Commodities had nominal losses in seven years, but the average loss was only 2.87 percent compared to 11.46 percent for equities. That is a big difference: more upside potential and less downside pain.

Fama and French (1988) connected industrial metals to the business cycle. Metal manufacturers do not react quickly to demand shocks at business cycle peaks, creating inventory shortages. When inventories are low, futures prices fall below spot prices and spot prices become more volatile. For precious metals, the results were weaker because storage costs are lower and inventories tend to stay high.

Kolb (1992, 1996) tested the Keynesian theory of normal backwardation across 29 commodities. Most commodities did not follow a clear contango or backwardation pattern. But commodities that are hard to store, like live cattle, live hogs, oil, and copper, did generate positive returns. This makes intuitive sense: difficulty of storage creates convenience yield, which leads to backwardation, which leads to positive roll returns.

Gorton and Rouwenhorst (2006) published one of the most influential studies. Using an equally-weighted index of commodity futures from 1959 to 2004, they found: positive correlation with inflation, negative correlation with stocks and bonds, and equity-like returns. This paper, along with Erb and Harvey (2006), was largely responsible for the flood of institutional money into commodities in the mid-2000s.

Then Things Got Complicated

Erb and Harvey (2006) found something uncomfortable alongside their headline results. On an historical excess return basis (above the risk-free rate), commodity returns were roughly zero. The “equity-like returns” people kept citing were partly driven by the collateral yield, not the commodity exposure itself.

They also introduced the concept of the diversification return, which is the extra return you get from periodically rebalancing a portfolio of volatile, uncorrelated assets. This is a real effect, but it is subtle. It comes from the discipline of selling winners and buying losers during rebalancing.

Erb and Harvey (2016) revisited their work and found commodity futures returned -4.6 percent per year between December 2004 and June 2015. Compare that to the S&P 500 at 7.4 percent and bonds at 4.5 percent. They blamed low income returns (roll yield plus collateral returns), pointing out that these periods of poor income returns can last a decade or more.

Bhardwaj, Gorton, and Rouwenhorst (2015) reached a different conclusion. They extended their original study through 2014 and found a 3.7 percent average annual risk premium, comparable to the long-term average. The key difference in methodology: they used an equally-weighted index, which reduces the influence of any single sector.

The disagreement between these two groups comes down to index construction. Erb and Harvey used volume-weighted indexes, which ended up being dominated by energy. Bhardwaj et al. used equal weights. This methodological difference produced dramatically different conclusions about whether commodities are worth holding.

The Supply and Demand Puzzle

Main, Irwin, Sanders, and Smith (2016) tried to explain why commodities had performed so poorly since the mid-2000s. Their conclusion: the academic studies from the early 2000s that touted commodity returns were partly responsible for the disappointment. Those papers attracted institutional money into commodity indexes, which may have changed the dynamics of the market itself.

They also argued that roll yields as described in the literature are a fallacy because of an apples-to-oranges comparison. Futures investors do not hold physical commodities and do not bear storage costs, so comparing futures prices to spot prices is not a fair comparison.

Their practical advice: long positions in low-storage-cost commodities and short positions in high-storage-cost commodities might generate returns.

The Long View

Levine, Ooi, and Richardson (2016) went all the way back to 1877 to study commodity futures returns. Over that very long period, commodity returns were positive on average. But they varied enormously based on inflation, business cycles, and whether markets were in contango or backwardation.

The finding that spot returns largely drive futures returns over time is important. It means that over the long run, what matters most is the fundamental supply and demand for the physical commodity, not the technical dynamics of the futures market.

My Takeaway

The honest answer to “what should you expect from commodity investments?” is that it depends on your time horizon, which index you use, and what is happening with inflation and the business cycle.

The strongest case for commodities is diversification. Their negative correlation with stocks and bonds is well-documented across decades. But the idea that you will earn equity-like returns from a passive commodity allocation is not supported by recent data.

The roll yield is the wild card. When commodity markets are in backwardation, the roll yield adds meaningful returns. When markets are in contango, it destroys them. And predicting which regime you will be in is not easy.

If you take one thing from this chapter, it should be this: never look at historical commodity returns without understanding the methodology behind the numbers. Equal-weighted vs. production-weighted, the time period chosen, and whether energy dominates the index can all flip the conclusion from “commodities are great” to “commodities are terrible.”

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