How Could We Have Been So Wrong?

Investments into commodity-linked investments have grown considerably since their popularity exploded—along with commodity prices—in 2006 through 2008. Numerous individuals and institutions have embraced alternative investments for their purported diversification properties and “equity-like” returns; yet, real-time performance has been disappointing. As an example, Morningstar reports that the iShares S&P GSCI Commodity Index Trust lost an annualized 9.1% in the 5 years ending December 31, 2012. The puzzling aspect of this poor performance is that it occurred at a time when the overall trend in commodity prices was sharply upward. In this paper, we explicitly show that the disappointing returns for commodity index investments were not directly caused by the futures market structure, i.e., “contango.” Rather, the implicit—and unavoidable—cost of holding physical commodities is inherent in futures prices and thereby creates a necessary performance “gap” between the returns to long-only futures positions and observed spot market prices.