📚 PASS Investment Adviser (Level 1) Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 7.4 — Commodities

Imagine you are an analyst at a Mumbai-based brokerage firm reviewing a client’s exposure to agricultural commodities. You notice that while the spot price of refined sugar has remained relatively stable over the last quarter, the client’s portfolio has suffered significant mark-to-market losses. Upon investigation, you realize the client is long on near-month futures contracts that are suffering from contango, where the futures price is higher than the expected spot price.

This scenario highlights a critical reality: commodity exposure is rarely achieved through the physical asset, but rather through derivative instruments that introduce complex mechanics like roll yield and margin requirements.

In the Indian context, commodities are primarily traded through national exchanges like the MCX or NCDEX using futures and options contracts. Unlike equity markets, where a stock can be held indefinitely without additional cost, commodity futures require the investor to ‘roll’ their position as expiration approaches. This involves closing out an expiring contract and opening a new one in a further-dated month.

If the market is in contango, the investor consistently sells low and buys high, leading to negative roll yield, which can silently erode returns even if the underlying physical commodity price moves favorably.

For an Investment Adviser, the inability to distinguish between spot price appreciation and the net return of a derivative-heavy commodity fund is a professional oversight. When building a portfolio, you must evaluate the ‘cost of carry’—the interest, storage, and insurance costs embedded in the futures price. If you recommend a commodity ETF to a client, you are not just recommending the asset; you are recommending a derivative strategy that is subject to tracking error and the structural biases of the futures curve.

Consider a case where an investor expects copper prices to rise due to increased industrial demand. If they purchase a long-dated futures contract, they must maintain a collateralized margin account at their brokerage. If copper prices remain stagnant but the cost of maintaining the futures position rises, the internal rate of return will be negative.

Consequently, your advice must incorporate not just a macro view on supply and demand, but also a technical assessment of the futures curve structure, ensuring the client understands that derivative-based commodity exposure is a tactical, time-sensitive instrument rather than a ‘buy and hold’ asset class.

Nuance

⚠️ Nuance
Many candidates falsely equate the movement of spot commodity prices with the returns of commodity-based derivative funds. They often ignore that futures prices are forward-looking and heavily influenced by the storage costs and interest rate differentials embedded in the ‘cost of carry’ model. A sophisticated analyst must verify whether a fund is ’long-only’ or ‘active-roll,’ as the mechanical process of rolling contracts can drastically alter the final return compared to the physical commodity price movement.

Check Your Understanding

Practice Question 1

An investor holds a long position in a commodity futures contract. If the market is currently in ‘contango,’ what is the most likely reason for the investor to experience a negative roll yield when the contract expires?

Practice Question 2

Which of the following is a primary risk factor for an Indian investor using commodity derivatives to gain exposure to gold, compared to holding physical gold bars?

This is a companion read for Section 7.4 — Commodities from PASS Investment Adviser (Level 1) by Akhilesh Gururani, available on Amazon Kindle.

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