The portfolios are constructed as follows: 1) the high roll-yield portfolio consists of the top one-third of commodities with the highest roll yields over the period, 2) the low roll-yield portfolio consists of the bottom one-third of commodities by roll yield, 3) the high-momentum portfolio consists of the top one-third of commodities by recent performance, and 4) the low-momentum portfolio consists of the worst performing one-third of commodities. All portfolios are rebalanced monthly. Commodities in each portfolio are equally weighted.
Going long the commodities with the highest roll yields and shorting those with the lowest roll yields over the January 1999–June 2016 period produced a 14.04% annualized return advantage. Furthermore, the best roll yields may at times include those in contango (just less-steep contango), and the worst may include lesser-backwardated curves. In the same vein, a 10.28% return difference was earned by going long the commodities with the highest momentum and shorting those with the lowest momentum.
Contract Selection. The second improvement in commodity index design is in contract selection, moving beyond the so-called front contract (the futures contract closest to maturity) to buy liquid contracts with better local roll-yield profiles relative to the rest of the futures curve.
In contrast, traditional commodity indices commit to the front contract only, despite the significant losses created by the approach when the front end of the curve is in strong contango.
Analyzing the period from January 1999 to June 2016, we find that selecting contracts with the best roll-yield profile has historically improved returns by 3.8% (4.0% – 0.2%) a year compared to the return of a contract selection method that buys the front contract only. Such an improved return is higher than we would reasonably expect going forward, but additional worthwhile benefits can be captured using this form of contract selection. Because the front-month contract is often the most volatile, removing the obligation of buying the front contract can also reduce the volatility of the commodity investment. For example, the annualized volatilities of the two contract selection methods over the study period are 25.0% and 29.0%, respectively, indicating a reduction in volatility for the best roll-yield-profile selection method. The best roll-yield approach also cuts turnover by one-half, on average, from 69% to 34%, and also typically lowers transaction costs.