We briefly discuss some common points of confusion regarding “roll yield”; that is, the return that a futures investor captures when their futures contract converges to the spot price. We then estimate the fraction of a trend follower’s portfolio that historically could be considered to have come from the roll yield.

What is the roll yield?

The price of a futures contract can be higher (contango) or lower (backwardation) than the current spot price. Among other things, a futures price can be dependent on expectations of future spot price, physical storage costs, and supply and demand pressures. However, the futures price will converge towards the spot price as the contract nears expiry. The return due to this convergence is called the roll yield; it is the difference between the spot return and the futures return.

Can trend followers make money from simply rolling contracts?

Despite the name, roll yield is not related to the act of rolling between contracts. When rolling a long position in a backwardated futures market, you sell contracts at a high price (near the spot) and take a new long position at a lower price. But you do not profit directly from this price difference…

In Figure 1, we consider the spot price (grey dashed), and the price of the front (closest to expiry) contract in the futures market (red) for a hypothetical commodity. In this example, the market is in ‘backwardation’ as the futures price is below the spot price. The futures price starts away from the spot price but converges towards it as the contract nears expiry. Once this contract expires, a new instrument with a new expiry date now becomes the front contract.

Figure 1: An example of a futures market in backwardation

If you buy the front contract, and hold it until expiry, the return you receive equals the change in price of the futures contract during the time you held it. In Figure 1 the returns are indicated by the blue arrows. One can also define a ‘roll offset’ – the price difference between the contract you sold, and the new contract you bought.

This is not a return you can gain in your portfolio because you closed out of one position (either at a profit or loss) and then opened a new one in a different instrument (for future profit or loss). The difference in price between those instruments is not a return-generating event.

Have trend followers profited from roll yield?

Despite not being a realisable return in a portfolio, roll offsets are a reasonable and simple proxy for measuring the roll yield over the long term, across many sectors, without knowledge of the spot prices or other datasets.

We consider a medium-speed trend-following strategy on 20 futures, spanning fixed income, equity indices, commodities, and currencies sectors [1]. We equally weight the sectors in terms of risk, and find a gross Sharpe ratio (excluding any fees or transaction costs) pf 1.2, for the 30-year period from January 1984 to December 2013, and an annual return of 13.5%. The breakdown of the results are shown in Table 1.

Table 1: Breakdown of sector and roll yield returns

We find that a third of the portfolio’s returns could be considered to have come from the roll yield in this generic trend-following strategy. And the result is relatively stable over the length of this simulation – finding corresponding values of 0.35, 0.37 and 0.25 for the decades 1984 to 1993, 1994 to 2003 and 2004 to 2013, respectively.

The roll yield is an intrinsic part of the dynamics of futures prices, but it is not simply the case that a trend follower serendipitously hoovers it up as a by-product of the strategy. Rather, the roll yield influences the trend followers’ positions – and had the yield been different, then the positions taken would have also been different. Ultimately, a trend follower predicts movements in futures prices, without distinguishing between the underlying forces driving the price dynamics.

Conclusion

The dynamics of a futures price are complicated and attributing the returns of a trend follower to roll yield is not trivial. However, we estimated that a simple trend-following strategy would find approximately a third of their returns for the past 30 years to have come from roll yield.

This article contains simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity and cannot completely account for the impact of financial risk in actual trading. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any investment will or is likely to achieve profits or losses similar to those being shown.