Morningstar Advisor - Summer 2008 - (Page 27)

the price, thus compensating for the cost of storage. If this is the case, we say that there is “backwardation” in the futures market. In a backwardated market, owners of a commodity in storage are being more than compensated for the costs of storage, but the compensation is not in monetary payments. Rather, it is in less-tangible benefits such as securing a supply of fuel as insurance against an energy crunch. Investors who are taking long positions in futures contracts, however, can realize this compensation monetarily by replacing the contracts that they are holding with longer-term ones, thus locking in profits. This component of excess return realized by investors is referred to as roll yield. In backwardated markets, roll yields are positive. Likewise, when the marginal benefits of storage are low, the relationship between time to expiration and the futures price is positive, a condition known as “contango.” In contangoed markets, roll yields are negative, because replacing contracts results in locking in a loss. The benefit of storage is high when inventories are low. For example, when a commodity is scarce, having it in storage will improve commercial consumers’ readiness to meet their needs in the near future, leading to backwardation and positive roll yields. Conversely, the benefits of storage are low when inventories are plentiful, leading to contango and negative roll yields. Because inventory conditions in some commodities are slow to adjust due to the time it takes to increase their production, backwardation or contango could persist for a period of time, causing investors to consistently experience positive or negative roll yield over the period. Thus, a passive investor should benefit from a trend-following strategy that incorporates roll yield into its signal. Building a Better Strategy Inconsistent Commodities: The three major bond and stock indexes have nearly identical risk and return characteristics. Commodity indexes, however, do not display the same level of consistency. 12% Stock Indexes S&P 500 DJ Wilshire 5000 Russell 3000 DJ-AIG Bond Indexes Citigroup USBIG Commodity Indexes Lehman Brothers U.S. Aggregate Merrill Lynch U.S. Domestic Master Index 8 S&P GSCI Compound Annual Return 4 RJ/CRB Standard Deviation 5% 10 15 20 Sources of Roll Yield: In a backwardated market, contracts increase in price as they approach expiration, creating a positive roll yield. Traders profit by “rolling” into less-expensive, longer-term contracts. In a contango market, the opposite occurs. Backwardation Contango Contract Price Contract Price Positive Roll Yield Negative Roll Yield 0 (Spot) Months to Delivery Sell Buy 1 2 3 0 (Spot) Months to Delivery 1 2 3 Passive strategies that use a momentum-based long/short approach rather than the long-only approach of the most common commodity indexes can better serve investors by attempting to capture the full excess return from a MorningstarAdvisor.com 27 http://MorningstarAdvisor.com

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Summer 2008

Morningstar Advisor - Summer 2008 Contents Letter from the Editor Contributors Inbox College Planning: Solutions and Concerns ETFs: The Next Chapter Engineering Financial Advice Investment Briefs Flexible vs. Style-Pure Managers: The Evidence Forging a New Commodity Index Work Your Way Through College Planning Sizing Up the Options Best and Worst 529 College-Savings Plans A 529 Travel Guide 10 Tax-Smart Tips for College-Savings Planning Global Dialogue How Sequoia Cranks Out Good Returns Year After Year The Many Layers of David Winters Living on the Edge Stocks to Buy Once a Decade With Munis Feeling the Pain, Some Opportunities Arise Health Care Provides Shelter from Economic Storm Help Your Clients Get More Out of Their Bond Portfolios Mutual Fund Analyst Picks 50 Most Popular Equity ETFs Undervalued Stocks Most Popular Variable Annuities New at Morningstar New on MorningstarAdvisor.com Closer to Fine

Morningstar Advisor - Summer 2008

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