CFA Level II ExamAlternative InvestmentsHard
A portfolio manager is considering an allocation to commodities. The manager notes that commodities can offer diversification benefits due to their low correlation with traditional asset classes, particularly during periods of high inflation. However, the manager is also aware of potential drawbacks. Which of the following is a significant drawback of investing in broad commodity indices, particularly those based on futures contracts?
- APredictable long-term capital appreciation
- BLow liquidity in futures markets
- CExposure to contango leading to negative roll yield
- DHigh dividend yields
Show answer & explanationAnswer & explanation
Correct answer: C. Exposure to contango leading to negative roll yield
A significant drawback of investing in broad commodity indices, especially via futures, is the potential for negative roll yield. When the futures market is in contango (longer-dated futures prices are higher than shorter-dated ones), investors rolling over their positions sell cheaper expiring contracts and buy more expensive new ones, leading to a loss from the roll yield component.
Why the other options are wrong
- A. Commodities are highly cyclical and volatile; their long-term capital appreciation is not predictable and can be negative, unlike some other asset classes.
- B. Major commodity futures markets (e.g., WTI crude, gold, corn) are generally highly liquid, especially for broad indices, so low liquidity is not a general drawback.
- D. Commodities, held directly or via futures, typically do not offer dividend yields; this is a characteristic of equities.
Commodity Futures Drawbacks
Potential disadvantages of investing in commodities via futures contracts, including negative roll yield in contango, lack of income generation, and high volatility.
- Negative roll yield in contango.
- No income (dividends/interest).
- High price volatility.
- Storage and insurance costs for physical commodities.
Memory trick: Commodities offer inflation hedge, but rolling can hurt.