Fortunately, there are techniques one can use to construct smarter commodity portfolios that both maintain attractive inflation protection characteristics and, at the same time, improve their performance. One example is shown in the last column of Table 3. This “smart” version of the equally weighted portfolio has significantly better performance than traditional equal weighting and the other two indices, both in times of low and high inflation.
A Smart Approach
What are the enhancements that generate improved performance while maintaining excellent inflation protection? The answer has to do with the mechanics of investing in commodities.
Betting on commodity prices via spot markets is impractical—or even impossible in some cases—leaving investors with no other option than to use derivatives, often futures contracts.6 In practice, one has to buy a futures contract, hold it for a few days or months, sell it before its delivery date, and immediately reinvest the proceeds in another contract. This constant process of moving from one contract to another is known as the “roll,” and depending on the shape of the term structure of futures prices, can significantly affect the end result. As a general rule, if a commodity is in contango—long-term contracts have a higher price than short-term ones—the investor faces a headwind, because contract prices have a tendency to go down as they approach the delivery date. The opposite case, or backwardation, gives the investor a tailwind, because contract prices move up over time.
Given the characteristics of commodity futures markets, it is useful to separate the excess returns obtained by investors into two components. The first one is usually called the spot return and is calculated by tracking the futures prices but ignoring the roll of the contracts. The second one is called the roll return and isolates the effect of the roll as if it were a separate investment. One cannot invest in either of these components separately, but they are a useful tool in evaluating the sources of return from an investment in commodity futures. Negative roll returns can be seen as a form of inefficiency that could be significantly reduced and even exploited in most cases.
Table 4 shows that all four portfolios had very similar spot returns of about 10% over the past 16 years.7 The similarities stop here, however. The first three had negative roll returns, reducing their excess returns to less than 5%. The simulated Smart EW portfolio, on the other hand, not only avoided a significant negative roll return, but was able to turn it into a positive 1.3%, raising its excess return to 11.7%.