- Investment Insights
- 3 minute read
Russia’s invasion of Ukraine has sent commodity markets on violent surges and dips in recent weeks adding another problematic dimension to central banks’ fight against inflation. Inflation matters to all of us in our daily lives – in the UK the severest real-income squeeze since the 1970s is being exacerbated by the war and the energy crisis. The tussle between inflation and interest rates will also likely define all investment returns this year.
Commodities are examples of real assets – physical and tangible holdings which may protect against inflation in the long run. Historically equities and property have done so too. The problem is that it is difficult to buy many commodities cost-effectively due to the high costs of carry associated with storage and transportation. Many investors simply could not take physical delivery of oil or wheat – two examples perhaps most-exposed to the current conflict – as this requires expensive infrastructure.
For many investment managers, the answer has been to buy an Exchange Traded Fund (ETF) offering exposure to an array of commodities to diversify holdings, protect from inflation and hedge out idiosyncratic risks as the cycles of different industrial products vary. An example would be the UBS CMCI Composite ETF which gives exposure to energy (oil, gasoline and natural gas), industrial metals (aluminium, copper, lead, nickel, zinc), precious metals (gold and silver) and an array of agricultural products (from cocoa to cotton and livestock) – 29 commodities in all.
Back to the Futures
Futures contracts (an agreement to trade at a fixed price and point in the future) are used to work around the cost of carry, but in order to avoid taking delivery of commodities whilst maintaining positions in the futures market, expiring contracts have to be continually replaced with new ones with later maturities. This pattern of rolling contracts forward before expiry creates roll returns which can be positive or negative. They are an important component of total returns together with price returns (what the commodities are worth today) and cash returns (earned from cash not used for margin requirements – effectively a percentage of a contract’s value put aside as insurance).
Without an ETF, futures contracts on 29 commodities would have to be rolled in this way across a fluid futures curve – complicated and costly. Normally, a futures market would show that prices in the future are higher than today’s (in contango), but this can reverse (in backwardation) adding another layer of risk. Generally commodities futures trade in contango but all of them are now in backwardation this year.
One problem with using the traditional front month rolling1 method for futures trading is that when an entire position expires during a fixed trading window, an investor is potentially exposed to illiquid trading and higher roll costs. Although costs for such longer-dated futures contracts tend to be lower, there is a greater chance that their value might diverge from the current spot price of the underlying asset.
The beauty of the UBS CMCI Composite ETF is that it uses the constant maturity method instead. This places multiple contracts out across the curve2 at different maturities in an attempt to avoid contract decay. Small contract positions are rolled daily and periods can be as short as a day. This does not entirely mitigate the inherent roll risk in managing complex futures trades, but it may outperform the traditional method at times.
There are other ways to attempt to diversify risk and make money from the rising costs of commodities. But you will currently find us using the UBS CMCI Composite ETF in several of our investment solutions, including the Close Managed Fund and Close Tactical Select Passive Fund ranges. As well as being a useful tool today in navigating choppy markets and protecting the real value of assets from the corrosive nature of inflation, the strategy helps us gain exposure to commodities critical to the transition to electric vehicles and the lowering of carbon emissions.
1The near or spot month, this is the nearest point in time when a futures contract will expire.
2Refers to a graph of contract prices plotted over time.
This article is only intended for use by UK investment professionals and should not be distributed to or relied upon by retail clients. The value of investments will go up and down and clients may get back less money than they invested. Past performance is not a reliable indicator of future returns. The information contained in this document is believed to be correct but cannot be guaranteed. Opinions constitute our judgment as at the date shown and are subject to change without notice. This document is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation.