In Part 1 of ‘Don’t let roll yield erode your commodity returns’, we explored how an optimised rolling commodity strategy can respond to changing market conditions arising from policy pressures;….
Nick Leung, Research Analyst at WisdomTree
better managing the roll return component and lowering volatility at the same time.
Part 2 explores another key driver for curve-optimised strategies, which is seasonality.
The futures curve for natural gas carries a distinct cyclical profile, as shown in Figure 1, underpinned by seasonal demand and supply dynamics such as surging demand in winter driving price expectations higher. The predictable premium in futures contracts, over certain points in the year, creates opportunities for dynamic rolling strategies to exploit, with significant implications for investors’ returns.
A front-month futures strategy will typically be positioned at the front of the futures curve. In the example above, this means positioning on the upwards sloping face of the curve as shown by the red dots, specifically holding the May 2016 and July 2016 contracts over the time period shown. Given the shape of the curve, the periodic rolling of expiring contracts into more expensive near-month contracts would incur negative roll yield, a drag on returns that would be amplified by the steepness of the curve over time.
By comparison, an optimised strategy would be holding further out futures such as Feb 17 contracts, denoted by the green dots. This would not only avoid negative roll yield entirely but in fact capture positive roll yield from positioning on backwardated sections of the futures curve. Continuously positioning around these seasonal patterns allows dynamic rolling strategies to materially outperform front-month strategies. Taking a look at natural gas in 2016, a dynamic rolling strategy would have returned 35%, against spot price increases of 59% and front-month rolling returns of just 10%.
So, what are the implications for investors?
It is our view that since seasonality is a characteristic shared by a wide spectrum of commodities, including agriculture and gasoline, fine-tuning forward curve positioning through a broad optimised commodity strategy can help investors capture additional returns and/or adapt to unpredictable seasonal elements across a variety of commodity exposures. The particularly volatile nature of seasonal commodities is also dampened by positioning further along the futures curve.
As a result, the prospect of lower volatility coupled with superior roll yield management offered by optimised commodity strategies is, in our opinion, a unique investment proposition that could enhance strategic investors’ portfolios. This can be complemented by also considering the capital efficient exposures offered by Boost’s range of short and leveraged ETPs for short-term tactical trading opportunities.