Roll Yield

Roll Yield is the return an investor generates from a futures contract position as it moves closer to its expiration date. It's a crucial, and often misunderstood, source of profit or loss in commodities and other markets where futures are traded. In essence, it's the gain or loss you make from “rolling over” your investment—that is, selling a contract that's about to expire and buying a new one with a later expiration date to maintain your exposure to the asset. The outcome of this roll depends entirely on the shape of the futures curve. If the market is in backwardation (future prices are lower than near-term prices), you can generate a positive roll yield. Conversely, if the market is in contango (future prices are higher than near-term prices), you'll face a negative roll yield. For many commodity investors, especially those using Exchange-Traded Funds (ETFs), the roll yield can have a far greater impact on their total return than the actual movement of the commodity's spot price.

Think of a futures contract like a pre-paid coupon for a product with an expiry date. If you want to keep your claim on that product beyond the expiry date, you can't just hold the coupon forever. You have to sell your old, expiring coupon and buy a new one for a future date. This process is called rolling over. The profit or loss you make from this transaction—the difference between the price of the expiring contract you're selling and the new, longer-dated contract you're buying—is the roll yield.

The direction of your roll yield, positive or negative, is determined by the market's structure. There are two key scenarios:

• Contango (The Headwind): A market is in contango when the price of a futures contract for a later delivery is higher than the price for a nearer delivery. This typically happens when there's an oversupply of a commodity or high storage costs (cost of carry).
  • An investor's experience: When you roll your position in a contango market, you are forced to sell your cheaper, expiring contract and buy a more expensive, longer-dated one. You're consistently selling low and buying high. This creates a drag on your returns, known as a negative roll yield. It's like trying to run up a down-escalator; even if the spot price of the commodity is rising slightly, the cost of rolling can wipe out your gains.
• Backwardation (The Tailwind): A market is in backwardation when the price of a futures contract for a later delivery is lower than the price for a nearer delivery. This often signals a current supply shortage and high immediate demand.
  • An investor's experience: In a backwardated market, you get to sell your expensive, expiring contract and buy a cheaper, longer-dated one. You are selling high and buying low. This generates a positive roll yield, which acts as a tailwind to your investment returns. It's a fantastic position to be in, as you can make money even if the spot price of the commodity stays flat.

While roll yield is a term born from the world of futures trading, its effects ripple out, offering valuable clues for the discerning value investor.

Many businesses are heavily exposed to commodity prices—think of an airline and jet fuel, or a cereal company and wheat. These companies use futures to hedge their input costs.

1. A company that must hedge in a persistent contango market faces a constant headwind, which can erode its profit margins.
2. Conversely, a company operating where its key commodity is in backwardation can benefit from positive roll yield, potentially giving it a sustainable competitive advantage. Analyzing the futures curve for a company's key inputs can provide deep insight into its future profitability.

Many investors get exposure to commodities through ETFs. However, most of these ETFs don't physically hold the commodity; they hold futures contracts. This means their performance is directly impacted by roll yield.

1. The Trap: An investor might see the spot price of oil rising and buy an oil ETF, only to find their investment value stagnating or falling. This is often because the oil market is in deep contango, and the negative roll yield is eating away at any gains from the spot price.
2. The Opportunity: Identifying commodities in backwardation can lead to investments in ETFs that benefit from the tailwind of a positive roll yield, adding an extra layer of return on top of any price appreciation.

The state of the futures market is a powerful economic indicator.

1. Backwardation signals scarcity and strong current demand, which can be a bullish sign for that commodity and related industries.
2. Contango suggests abundance or weak immediate demand, which can be a bearish signal.

Understanding roll yield allows a value investor to look beyond a company's balance sheet and gain a more nuanced view of the economic forces shaping its industry and its future.