Market participants have historically invested in commodity futures-based indices for their inflation protection and diversification benefits, given their low correlation to stocks and bonds. However, the returns earned from investing in commodities differ from those earned from traditional asset classes, in that commodities have no expected book value or expected cash flow, while a commodities’ value comes from the fact that they are consumable (like grains) or transformable (like petroleum) assets.
Physical commodities may be accessed through the cash spot market, but storage is costly and difficult. Natural gas, for example, is expensive to store and to transport since it has to be maintained in liquid form at sub-zero temperatures. Metals tend not to deteriorate over time, whereas grains and livestock do. Gold is costly to store because it requires expensive security.
Investing in commodities indices that are constructed using long or short positions in futures on physical commodities whose value is determined based on the price of the underlying physical commodity plus yield and that trade on public markets that provide adequate liquidity and transparency, with negligible costs and no storage deterioration risk, offer a practical method to gaining commodities exposure and can provide a means for market participants to access the five components of the returns of the asset class.
So what are the five, generally accepted components of returns in the commodities futures market?
The first is the insurance risk premium, which stems from the fact that producers of goods for public consumption (such as coffee, base metals, and petroleum), as well as the producers of these raw materials, wish to transfer the risk of price fluctuations to speculators, which in most cases are financial institutions.
The second is collateralization, since investment in commodities futures requires an initial margin, which is a small amount of cash that is calculated as a percentage of the notional amount of the commodity; fully collateralized versions are known as total return indices.
The third component is the convenience yield, which is the implied return on inventories and is regarded as the additional payment a commodity producer is willing to pay for the necessary raw material to ensure this input is available in a timely manner, in order to avoid delays or disruptions in production.
The fourth component is expectational variance, which is caused by unexpected inflation (supply-side shocks such as shortages) that results in sudden spikes in the price of a commodity.
The fifth component is rebalancing or roll return. The roll return is the difference in the price of the expiring contract and the next eligible contract. Futures contracts expire on a regular basis, generally monthly or quarterly. Futures-based indices must roll their long (or short position) into the next contract to maintain their exposure.
 Robert J. Greer, The Nature of Commodity Index Returns, The Journal of Alternative Investments, Summer 2000 and Calude V. Erb and Campbell Harvey, The Strategic and Tactical Value of Commodity Futures, Financial Analysts Journal, Volume 62, Number 2, 2006.