One of the drivers of long-only commodity indexes was the return these vehicles earned from normal backwardation — further out futures contracts trade at a discount to the near-term contract. Conversely, when markets move into contango — further out contracts trade at a premium to the near month — it serves as a drag on returns as the indexes roll.
As long-only commodity investments grew, indexers became concerned over the effect of contango on performance, especially in crude oil, which receives the largest allocation in these indexes.
In August, Dow Jones Indexes announced the imminent launch of the Dow Jones-UBS Roll Select Commodity Index, which aims to mitigate the effect of contango on index performance. "Contango has a big negative impact on performance," says Jamie Farmer, executive director — global business development for Dow Jones, which is looking to license the new index.
The index will have the same rules as its main commodity index, except when it is time to roll it will look out over nine months and roll each of the 19 components (that need to be rolled) into the contract month with the least contango or greatest backwardation.
In January, S&P launched its S&P GSCI Dynamic Roll Index, which extends out as far as there are liquid contracts — as long as four years in crude oil or less than a year in other components — and already has $1 billion benchmarked to it. As of mid-August it has outperformed the core GSCI, 3.66% to -1.52%.
Walter (Tom) Price, president of Beeland Management and a member of Rogers International Commodity Index Committee, says a back month contract may not react the same way to events such as a hurricane or drought as the front month. A study his firm published concluded that backwardation or contango should not drive investment decisions.
While the contango busting indexes should outperform the originals, the cost of replicating them would be expected to be higher rolling into the less liquid contracts. However, the process would save on execution costs as there would be less rolling.