Learning Outcomes
This article explains how commodities and real assets are managed using futures contracts and prepares you for typical CFA Level 2 exam questions on this topic. It clarifies the main sources of risk in these markets, including price volatility, seasonality, geopolitical and regulatory factors, and the additional risks introduced by rolling futures positions over time. It explains how fully collateralized commodity futures positions generate total return, decomposing performance into spot return, collateral return, and roll return, and shows how the shape of the futures curve in contango or backwardation affects roll yield for long and short investors. It discusses how futures are used to hedge commodity and real asset exposures, tactically adjust portfolio allocations, and replicate or complete desired exposures when spot markets are illiquid or operationally difficult. It analyzes key implementation risks such as basis risk, liquidity constraints, margin amplification, and roll risk, and links these to common performance attribution and risk-measurement techniques. It also highlights practical exam-relevant calculations and interpretations, enabling you to evaluate hedging effectiveness, interpret futures curve movements, and assess whether observed returns are driven primarily by spot price changes, collateral yield, or roll yield.
CFA Level 2 Syllabus
For the CFA Level 2 exam, you are expected to understand the fundamentals of risk management and implementation techniques using futures in commodities and real assets, which are critical for both constructing and analyzing portfolios, with a focus on the following syllabus points:
- Explain sources of risk in commodities and real assets sectors
- Analyze the relationship between spot and futures prices (contango and backwardation)
- Calculate and interpret total return and its components for a fully collateralized commodity futures position
- Describe how futures contracts are used to implement exposures and manage risk
- Apply risk management concepts (e.g., roll return, collateral yield) to practical portfolio decisions
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which three components determine the total return of a fully collateralized commodity futures investment?
- If the futures price of a commodity is above its spot price and rising with maturity, what is the expected sign of the roll return for a long investor? Explain.
- Discuss how futures-based strategies can reduce risk in a real assets portfolio.
- What type of market condition (contango or backwardation) results in positive roll yield for a long futures position?
Introduction
Commodities and real assets present both return opportunities and significant risks to investment portfolios. Effective risk management in these sectors requires a sound understanding of how futures contracts are used not only to gain or reduce exposure but also to control sources of return and risk unique to commodities. This article explains how futures-based strategies are constructed, what drives their return, how to measure and control risk exposures, and common pitfalls to avoid for the Level 2 exam.
Key Term: Commodities
Physical goods such as energy products, metals, livestock, grains, and softs, which are investable through spot or derivative markets and exhibit unique risk/return characteristics.Key Term: Real Assets
Tangible assets, including real estate, infrastructure, and natural resources, valued for their fundamental or functional properties, often held to diversify portfolios and hedge inflation.Key Term: Futures Curve
The graphical representation of futures contract prices for different maturities on the same reference commodity, reflecting market expectations, storage costs, and risk premiums.Key Term: Roll Return
The return component of rolling expiring futures contracts into new ones, influenced by the shape of the futures curve (contango or backwardation).Key Term: Collateral Return
The interest earned on cash or securities held as collateral for a fully collateralized futures position, typically proxied by short-term risk-free rates.Key Term: Spot Return
The price change in the reference commodity or asset, measured by the gain or loss on the spot price over the investment period.
Risk Sources in Commodities and Real Assets
Investing in commodities and real assets exposes investors to specific risks:
- Price volatility caused by supply/demand shocks
- Seasonality, weather, storage, and transport interruptions
- Geopolitical factors and regulatory changes
- Rolling risk due to needing to maintain exposures over time with exchange-traded futures
Highly volatile prices make direct investment risky and often impractical because of logistics or illiquidity in spot markets. Futures contracts offer a practical method to express views and manage these risks.
Futures-Based Implementation: Return Components
A fully collateralized long position in a commodity futures contract delivers a total return that is the sum of three elements:
- Spot Return: The change in the reference commodity's spot price.
- Collateral Return: The return from investing the collateral backing the futures position, typically in short-term government securities.
- Roll Return (Roll Yield): The profit or loss from closing out maturing contracts and entering new ones at prevailing futures curve prices.
Mathematically:
Understanding the Futures Curve: Contango and Backwardation
The futures curve is upward sloping (contango) when futures prices are higher than spot prices and increase with maturity. This usually reflects high storage costs or abundant supply. It is downward sloping (backwardation) when futures prices are below spot prices—common during periods of limited inventory or high convenience yield.
- In contango markets: rolling from an expiring lower-priced contract into a more expensive one creates negative roll return for long investors.
- In backwardation: rolling into cheaper new contracts than the expiring contract produces positive roll return.
Key Term: Contango
A market condition where longer-dated futures prices exceed spot prices, typically resulting in negative roll return for long positions.Key Term: Backwardation
A market condition where futures prices are below the spot price, resulting in positive roll return for long positions.
Worked Example 1.1
A commodity fund is long July wheat futures at 420. When July approaches expiry, the fund rolls into October wheat futures at 430.
What is the roll return on this rollover?
Answer:
Roll return . The negative roll return reflects contango: the fund must pay more to maintain exposure.
Worked Example 1.2
A portfolio is long copper futures. The expiring May contract is priced at $8,000, while the new August contract is $7,900. The spot price of copper remains unchanged.
What is the roll return from rolling May to August?
Answer:
Roll return . Here, backwardation in the futures curve produces positive roll return.
Futures for Risk Management and Exposure
Futures contracts are central to real assets portfolio implementation:
- Hedging: Producers and consumers can lock in future prices using short or long futures, reducing exposure to spot price swings.
- Tactical adjustments: Portfolio managers shift sector allocations by taking long or short futures positions rapidly, without trading physical assets.
- Replication: Investors gain commodities exposure using futures when spot holdings are impractical or illiquid.
- Portfolio completion: Missing or hard-to-access assets can be simulated using liquid futures.
Managing and Measuring Risk
Futures-based strategies carry unique risks:
- Basis Risk: The difference between futures and spot price movements, potentially causing imperfect hedges.
- Liquidity Risk: Some commodity futures are thinly traded, leading to wider bid-ask spreads or slippage.
- Margin Amplification Risk: Futures require only margin collateral, amplifying both gains and losses.
- Roll Risk: Negative roll return can reduce returns, especially in contango markets.
Risk measurement commonly includes:
- Tracking error versus benchmark indexes (due to imperfect replication or roll yield)
- VaR (Value at Risk) to estimate tail risk during volatile periods
- Sensitivity to curve shape and changes in storage or convenience yield
Practical Implementation Issues
Implementing futures strategies involves frequent rolling as contracts near maturity. This requires:
- Monitoring the futures curve to anticipate roll costs or benefits
- Choosing appropriate contract maturities (liquidity and cost)
- Managing collateral efficiently to maximize collateral return
Worked Example 1.3
A manager wants to keep a $2 million notional exposure to oil using quarterly futures. Current one-month T-bill rate is 3% annualized. If $2 million is posted as collateral for a year, what is the collateral return?
Answer:
Collateral return = $2,000,000 × 0.03 = $60,000 over one year.
Revision Tip
Always decompose total return when assessing performance or risks in commodity futures-based portfolios. Recognize the impact of negative roll yield in years when the market is in contango.
Exam Warning
It is a common mistake to attribute all gains or losses in a commodity futures strategy to spot price changes. Remember, the roll yield can be negative even when spot prices are unchanged or rising.
Summary
Risk management for commodities and real assets relies on an understanding of futures-based implementation. Returns from these strategies derive from spot price movements, collateral yield, and roll return, each influenced by market structure, storage costs, and curve shape. Contango markets tend to erode long futures returns via negative roll yield; backwardation can provide positive roll yield. Futures contracts enable precise, efficient exposure and risk control, but require attention to portfolio rolling, margin, and market risk factors.
Key Point Checklist
This article has covered the following key knowledge points:
- Describe main risk sources in commodity and real asset investing
- Identify and calculate the three main components of total return for commodities futures strategies: spot return, collateral return, roll return
- Distinguish between contango and backwardation and their impact on roll yield
- Evaluate the practical use of futures contracts for risk management and portfolio implementation
- Recognize common risks and operational considerations in futures-based commodity portfolios
Key Terms and Concepts
- Commodities
- Real Assets
- Futures Curve
- Roll Return
- Collateral Return
- Spot Return
- Contango
- Backwardation