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Major gains in energy sector followed by the grains market helped commodity returns gain significantly in October, the largest monthly gain since May this year.In The MLCX TR index returned 6.98%, the DJ-UBS TR index posted 3.28% and the
S&P GSCI TR returned 5.87%.

According to an Bank of America-Merrill Lynch (BofAML) analysis, commodity bull run would continue well supported by a 4.3% global GDP growth in 2010 and 4.5% in 2011.But negative roll yields remain a stone in investors’ shoes, the analysis said.

Despite the good returns this year and the positive outlook for the asset class, investors continue to battle against the high cost of carry in commodity investments. While commodity prices are up by 42% since the start of the year according to the S&P GSCI spot index, the S&P GSCI ER index is only up by 11%. As a result, many investors are wondering what can be done about the negative carry despite being positive on the outlook for the asset class.

Using MLCX long-dated rolls to limit negative carry
While many investors agree on the positive outlook for commodities ahead, most are still wondering what can be done about negative carry in commodity investments. This is a critical issue, as negative carry in near-dated commodity investments makes market timing a lot more relevant. For instance, excess commodity returns were flat in the May to September period, but roll returns were -5.7% during that time. Because roll returns have remained persistently negative, strategic investors have been at a disadvantage relative to tactical investors in recent months. Paradoxically, many strategic investors find themselves in a situation where they want to either enter or increase their exposure to commodities but do not know when to do it due to the negative carry associated with traditional long commodity index strategies such as the S&P GSCI TR or the DJ-UBS TR.

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The MCLX Agriculture Index is BofAML effort to develop a tradable enhanced beta product combining long-dated exposure with BofAML's understanding of seasonality in some key agricultural markets. With manyasset allocators trying to increase exposure to commodities, long-dated indices can help investors focus on portfolio construction instead of on market timing.It has also been previously stated that long-dated rolls offer an appealing method of gaining exposure to crude oil prices or agriculture. Now, this strategy has been proved to be useful for a broader spectrum of commodities, BofAML analysis said.

Long-dated strategies can reduce the negative roll returns across a broad range of commodity markets,particularly for commodities that are hard to store. Thus, rather than trying to time the market, the BofAML report recommends investors with a cross-asset strategic mandate to gain exposure to commodities straight away through long-dated commodity strategies. Dynamic “optimal yield” rolling strategies tend to roll very often and wide bid-offer spreads can reduce the benefits of frequent rolls. But even leaving replication costs aside, BofAML analysis shows that the reactive dynamic optimal yield approach may actually turn out to underperform systematic long-dated rolls with similar or longer maturity. The report stated that “optimal yield” rolling strategies perform well because they give investors long-dated exposure, not because they are dynamic.

Commodity returns finally catching up with equities, bonds
After several months lagging the rally in fixed income and equity markets,commodities had a good run in October. Of course, one would expect anticipatory assets to rally ahead of a tightening in physical supply and demand fundamentals that underpin commodity markets. While commodities lag other asset classes, commodity indices like the S&P GSCI and the DJ-UBS are still up 42% and 30% from their low point this year (Chart 2). Looking forward, with our economists forecasting global GDP growth of 4.3% in 2010 and 4.5% in 2011, the improved fundamental picture combined with the recent surge in money supply should continued to drive commodity prices higher.

Alternatively, long-dated rolls mitigate negative roll yields
Long-dated indices can also be used as an alpha engine By combining enhanced beta commodity exposure with traditional commodity index benchmarks such as the S&P GSCI and the DJ-UBS in a long/short format, investors are able to package structural alpha into a single strategy. In BofAML view, the distinction between enhanced beta and pure alpha is much
more than just taxonomy of commodity investment. After eliminating the directional exposure to any particular commodity by matching single-commodity exposures on their long and short legs, investors can choose to allocate commodity alpha to any absolute return portfolio, not only to their commodity portfolio.

When looking at alpha, conventional weights are irrelevant Moreover, when constructing this basket of pure alpha trades, the weights of commodity index benchmarks are not necessarily the optimal weightings. Like market-cap weighting schemes in equity indices, commodity indices such as the S&P GSCI or the DJ-UBS are designed to reflect the relevance of each
commodity market in the global economy. Hence, clients are encouragedto adapt the weights of their basket of structural alpha trades to their risk-return profile, BofAML report added.

Since January 2004, commodities have broadly outperformed traditional equity indices, but there has been diverse performance among commodity indices. Specifically, the MLCX TR index outperformed the Standard & Poor’s US 500 TR index by 7.56% on average per year. However, the same comparison for the S&P GSCI TR index yields -1.08% and for the DJ-UBS TR index the relative performance is 1.46%. In the time period, EM equities fared better than commodity indices while the ML US Broad Market Bond index outperformed the S&P GSCI TR and the DJ-UBS TR indices, although its return did not exceed the yearly performance of the MLCX TR index..