As April showers give way to May flowers, farmers are well on their way to planting their crops for the year. Most have spent the harsh winter months cooped up indoors preparing for the new season, undoubtedly thinking about current prices for their crops and where they might be later in the year. Luckily, there’s a wide array of spot prices—prices for immediate sale—that offer farmers a quick proxy of where corn is trading or how much a bushel of wheat is going for. These prices, along with the futures prices that derive from them, can help farmers prepare for the upcoming season and can even guide which plants go into the field. 

In the same way that spot prices are useful to farmers, they can be just as useful for investors. Many index providers recognize this and publish asset-class-wide measurements of aggregate spot prices called spot indexes. Most of us have a general understanding of how spot indexes work in the context of stocks and bonds. When it comes to commodity spot indexes, however, things can get a bit complicated if you don’t understand their subtleties. A bit of complexity doesn’t necessarily make commodity spot indexes bad; they have useful benefits for many investors in tracking general commodity price movements.

To unshroud the mystery, let’s look at commodity spot indexes, why they can be confusing for investors, and how you can prevent getting caught up in uncertainty when thinking about your own commodity investments.

What’s a commodity spot index?

Spot indexes in the commodity asset class are somewhat nuanced in that they don’t actually represent true spot prices of the underlying commodities. This is different from how spot indexes are constructed for other asset classes such as equities and bonds, where the indexes are made up of physical securities.

Commodity spot indexes are made up of baskets of near-maturing commodity futures contracts on the underlying physical assets. This can cause some confusion for investors when those contracts mature and must be reestablished in the index. This process, sometimes referred to as rolling, is commonly thought to create a return from its mechanics. The prospect of a return is what investors speak of when referencing the infamous roll yield in commodity investing. The only problem is it doesn’t really exist.

What’s so confusing about commodity spot indexes?

As with any investment, the mere process of selling one asset and purchasing another—or even making a transaction with the same asset—probably won’t create any profit or loss from that transaction alone. The same holds true when an investor sells a maturing futures contract and purchases a further-dated contract. The confusion arises from how index providers have chosen to account for this process in their spot indexes.

When constructing a spot index, providers consider only the current prices of the futures contracts in the index. This allows the index to replace a maturing contract by simply substituting in the price of the new contract, which essentially treats the roll yield as an index gain or loss. However, rolling from one futures contract to another doesn’t actually result in any profit or loss for investors who own the same portfolio as the index. Because of this, a live futures portfolio will deviate from the spot index by the roll yield.

Spot index return versus futures return (example)

Sources: CME Group, Parametric, Bloomberg, 12/31/2019. This is a simplified index roll example. In reality, the index rolls from one contract to another over a five-day window. For illustrative purposes only. Not a recommendation to buy or sell any securities. Actual result will vary.

The above example shows the prices of two contracts for corn: one expiring in December and the other in March. At the close of trading on November 11 the index rolls from a December expiration to a March expiration. This roll means the index will now track the price of the March contract in place of the December contract. The spot index reflects the roll by showing the closing price of the December expiration through November 8 before showing the price of the March expiration starting on November 11.

By not accounting for the index roll, the spot price jumps to the new contract price and assumes a return in the process. A futures investor wouldn’t be able to make this maneuver. Instead, at the end of November 11, the investor would close the futures position in the December contract by selling it at $373.25 and open a new one in the March contract by purchasing it at $382.00. While the futures investor experiences no profit or loss from this transaction, the spot index does, with the index price increasing by the $8.75 difference between the two contracts. This results in underperformance for the futures investor versus the spot index and is categorized as a negative roll yield. The existence of a roll yield at all is simply the result of comparing returns of a live portfolio against an index return that isn’t achievable by design.

The curious case of spot returns

It’s become common over the past few years to point to a negative roll yield as proof that commodity investing is a bad idea or evidence of why the asset class has struggled with underperformance. In reality the roll yield is merely a representation of the physical costs an investor would face if purchasing commodities like a bushel of corn or a barrel of oil—costs that get ignored when simply looking at a spot price return. 

Commodity spot indexes were created as a way to track general price movements of the asset class, a purpose they serve fairly well. However, when we think about an investment in the asset class, spot indexes break down as a suitable benchmark given the nuances created in their unique methodologies and the unavoidable reality that they don’t represent what an investor might actually be able to experience. Instead, investors looking to compare how their own portfolios measure against those of an unbiased competitor should compare results against the total return version of the spot index. In doing so, investors get a benchmark that accurately accounts for the process of rolling over maturing futures contracts. The total-return version of the spot index also adds in a Treasury bill return, bringing it on par with physical investments in the asset class. But that’s an entirely different topic for another time.

The bottom line

Commodity spot indexes generally track spot price movements and are a convenient proxy for the asset class. However, they shouldn’t be viewed as the benchmark for a commodity investment given the possibility of their performance not being achievable. Similar to stocks and bonds, the total-return version of your favorite index would be a better measurement of your return potential.