Calculating returns on futures contracts: What’s right, what’s not

Hendrik Bessembinder has no problem setting people straight about the stock market or busting myths about futures investing.

One of his most attention-getting papers showed how the conventional wisdom that stocks outperform Treasury bills was incomplete because in truth only a few stocks were responsible for the market’s overall gains.

“That [stock market] paper had the flavor of ‘keep what you thought you knew, but here are some additional things you should also know,’” he says. “This [futures market paper] has the flavor of, ‘some people need to forget what they know — because it’s wrong.’”

In his latest research paper into futures contracts, the professor of finance and Francis J. and Mary B. Labriola Endowed Chair in Competitive Business tackles what he calls the “roll yield myth.” Investors who regularly trade in futures contracts understand what determines their gains and losses, he says, but some financial journalists, market commentators, and investment advisors inaccurately explain the nature of yields on a series of such contracts.

Whether the contracts involve future prices of corn or soybeans, crude oil, or the Dow Jones Industrial Average, investors who wish to maintain a long-term position in futures contracts must sell, or exit, the contracts before they expire and “roll” their position into new contracts with later expiration dates. The myth is that this rolling activity generates a cash flow or yield.

Why the contract confusion?

Confusion over calculating investors’ returns on futures contracts appears to be widespread, Bessembinder says. Among the examples he cites are a 2014 Wall Street Journal story on commodity trading that said “the investor sells the contract, buys a cheaper one for delivery at a later date, and pockets the difference,” and a 2010 Bloomberg column on rising futures prices that said when commodity fund managers sell expiring contracts and “buy the more expensive contracts … they lose money for their investors.”

Bessembinder says confused observers mistakenly focus on the point in the process when investors exit one contract and enter another one. They think that when investors “roll” from one contract to another, they have a gain, or “yield,” based on the difference in the contracts’ prices on the “roll” date. For example, these observers presume that if investors sell a contract for a commodity to be delivered in October with a futures price of $82, and then buy a contract with a futures price of $81 for the same product to be delivered in November, they’ve made a profit of $1.

“That’s the myth, that you pocket or pay that difference in prices,” he says. “There’s a presumption that you sell the expiring contract, receive the futures price, purchase the next contract, pay the futures price, and you either pocket or pay the difference in the two prices. In fact, what they refer to as the the roll yield will never be debited or credited to your margin account.”

The concept is comparable to thinking that just because a company books goodwill or depreciation on its financial statements, those items flow as cash into or out of investors’ accounts.

The truth about futures

Instead, Bessembinder says, people need to understand that what futures investors gain or lose is based on the change in the contract’s price during the time their position is open — that is, from the time of purchase to the time of sale. An investor who buys a contract at a specific price will gain if the price rises over time and lose if the price falls over time. For example, investors who bought that October contract with a futures price of $75 and sold it later when the futures price was $82 turned a profit of $7. If they then buy the November contract with a futures price of $81 and sell it when the futures price is $83, they turn a profit of $2, bringing the gain for those two contracts to $9.

The $7 and $2 changes over time in futures prices for those contracts create real gains, but the apparent $1 gain, or yield, on the roll date, does not, Bessembinder says. “What does matter for a futures investor is the change in the price of the contract while you have a position,” he explains. “That’s the only thing that matters.”

Bessembinder says he wrote the paper to educate potential futures investors and their advisors, and he submitted it to Financial Analysis Journal because of the publication’s broad reach. He hopes it will stop investors from entering futures contracts on the belief they will earn a periodic cash flow from “roll yields.” He also hopes it will curb investment advisers and the financial press from suggesting that roll yields are amounts that investors receive or pay.

Most of the reaction he’s received so far to his myth-busting has been positive, with readers thanking him for clarifying the issue. As to the handful of readers who resist letting go of their myth, Bessembinder stands firm. “There are very few places where I dig in my heels,” he says, “and this is one of them.”

By Jane Larson