Managed futures: Can you make water into wine?

I’ll tell you right up front: I have investments in commodities futures. I’ll try to explain why. Commodities futures are quite distinct from commodities themselves, and lots of folks get them mixed up. To buy a commodity, such as copper, is to buy some of the metal itself.

A copper futures contract is another thing entirely. You do not own the metal. You have instead entered into a contract to buy some of the metal at a pre-determined price. This is called a long position in the contract. Somewhere, some other party has entered into a contract to sell the same amount of copper at the same price. This is called a short position in the contract.

Since all of these long and short contracts exactly total into a net neutral position, what happens to all of the futures participants if the price of copper rises? Nothing, in aggregate. Profits equal losses. In a perfect theoretical world, there are no winners or losers over time. So, why bother to invest in futures?

The answer is that diversified portfolios of commodities futures have shown signs over the years that gains consistently tilt to the side of the long contract holder. The traditional explanation for this is that an industrial producer of a commodity, say a copper mine, wants protection from market declines in the price of its commodity.

If copper is selling for $2 per pound right now, the mining company might be inclined to invest in a new digging site. Its risk is that copper drops to $1.50 per pound, and the mine loses money. So, to insure against a loss, it sells future deliveries of copper at, say, $1.80 per pound.

In all likelihood, copper will still sell for $2 when the contract matures, and the company loses 20 cents per pound. That 20 cents can be thought of as an insurance premium that the company is willing to pay to reduce its risk of loss.

When a futures contract price is persistently below the expected sale price of the commodity, money will steadily flow from the short holder of a futures contract to the long holder. This theory of futures market behavior is known as normal backwardation and has been posited since at least 1930, in a work by legendary economist John Maynard Keynes. This steady profit is also known as the roll return since expiring contracts are repeatedly rolled over into new ones.

The trouble with the futures-as-insurance concept is that it doesn’t hold true on closer examination of many different commodities. Some commodities futures exhibit positive roll returns, others don’t,