Q. So these are a very important idea for investors to understand, especially those whose advisors have them in commodities…
A. Yes. Commodities obviously have lots of potential roles to play in a portfolio, especially non-correlation and diversification. But exactly how you invest in them is really important. Mostly, the investments occur through futures contracts… and if you’re not careful you can easily be the victim of “roll losses” that easily result in underperformance.

Q. OK, now, I’d guess that ETFs are a popular way to invest in commodities… is this an issue for those kinds of instruments?
A. Very much so, because generally the ETFs are holding futures contracts… and that’s why, for many people, roll losses are a very hidden risk. We’ve talked about the main culprit before: Contango– viewers can Google it for our explanation. To summarize, this is a normal condition in futures contracts, where the future price of a commodity exceeds its spot price, often because of storage and time value of money costs that would result from buying a commodity today that you won’t use for many months.

Q. OK, so usually commodities investors are buying a futures contract where the price of the commodity is actually higher than in today’s spot market?
A. Right. But over time, that disparity usually disappears (assuming no movement in the underlying spot price)– the value of not storing the commodity slowly diminishes and gets to almost zero by contract expiration. So, its very easy to buy a commodities futures contract and lose money on it even if the price of the commodity goes nowhere, or even if it increases somewhat.

Q. And the ETFs that invest in commodities through futures contracts are subject to this phenomenon?
A. Absolutely. They buy a futures contract, hold it until near expiration, and then roll the money into a new contract. That’s where the “roll losses” can occur– essentially, you’re buying high and selling low.

Q. But surely this is taken into account by at least some ETFs?
A. Yes, they try to spread out expiration dates, length of contracts, and do other things to manage this risk. But it’s a very real issue for people who think they can just buy commodity ETFs without understanding this point.. They can suffer meaningful “roll losses” if the commodity goes nowhere, and sometimes even if the price goes up.