Investing in Commodities

Contango - futures price is above the spot price.  "Long hedger" will buy a futures to protect against unexpected price increases.  Long hedgers bid up the price of commodity futures, and paying a premium for the hedging benefit they get from taking long future positions.

Backwardation - futures price is below the spot price.  Dominant traders are producers who are hedging against future price declines in the future.  These are typically the case, so this is often called 'normal backwardation.'

Risk and Return of Commodities and Effect on Portfolios
Investor will typically get exposure to a commodity through derivatives (forward or future).
To take a position an investor must post collateral.  If treasuries are the collateral, the collateral yield is the yield on the T-bills.  Active management on the collateral (within bounds) can increase the yield.

The price return on a long investment can be positive or negative.  Depends on direction of change in the spot price for the commodity over the life of the derivative.

Since contracts expire you need to close out and re-establish if you want to maintain exposure.  This is called 'rolling over' the position and leads to gains/losses called the roll yield.  Futures price at expiration must equal the spot price at that time.  In backwardation, roll yield is positive.  In contango, roll yield is negative.

Adding a long commodities position to a portfolio can be great for pension fund portfolios - they tend to not be correlated with equities (good diversification) and can serve as a hedge against inflation.

Commodities indexes are an active strategy because it is necessary to re-establish positions to maintain the same exposure.  Managers add value by choosing the maturities of the contracts they buy and by their decisions about when to roll over.  If many long-only investors roll at the same time they pay a premium in transaction costs, reducing both roll yield and overall yield of the index strategy.

Another aspect of active management has to do with weighting.  Weightings of commodities don't necessarily change with the changes in the prices of futures.  Must actively manage this as positions are rolled over.  Additionally, the short term debt used to collateralize positions must be managed.  These debt securities mature and can be replaced with better ones based on market conditions.