Canadian Investment Review

Commodities and the Efficient Frontier

Written by Nick Koutsoftas, Ben Ross and Geoff Fila on Thursday, June 10th, 2010 at 9:18 am

1223184_wheat_fieldIn the context of modern portfolio theory the objective of most investors is first, to use a portfolio on the efficient frontier that is commensurate with their return/risk preferences and second, to find ways to shift this efficient frontier toward more return and less risk. This may explain why investing in commodities to improve a portfolio’s risk return tradeoff is gaining wider acceptance among institutional investors. This article discusses the growing interest in this asset class as a potential portfolio diversifier, the investment characteristics of commodities, various strategies, available benchmarks, sources of return, and ways to gain more active exposure to this unique asset class.

In the search for portfolio diversification and protection against unexpected inflation, many investors have increased their allocation to commodities from the low base at the beginning of this decade. Assets under management in the commodities market increased from approximately US$5 billion globally in 2000 to US$80 billion in 2005 and analysts expect the cumulative figure to surpass US$250 billion this year.1

Commodities are being added to portfolios for the following reasons:

To mitigate risk and improve portfolio diversification, given commodities’ low correlation with other asset classes.

As an up-and-coming asset class, commodities have been no stranger to academic dissection over the years. As a result, it is well established that commodity returns demonstrate low-to-negative correlation with stocks and bonds. We believe this characteristic explains much of the recent interest in commodities, as investors seek to protect themselves from market volatility through greater diversification. By reallocating a modest percentage of a portfolio to commodities, we believe overall volatility may be reduced without sacrificing return.

To provide a possible hedge against unanticipated inflation

Commodities are positively correlated with inflation indicators and have performed well when inflation was rising, even from a low base. In contrast, inflation tends to weigh on stock and bond returns. In addition, commodity prices often respond favorably to catastrophic event shocks (e.g., drought, geopolitical tensions, war, hurricanes) that periodically threaten oil, agricultural or other resource supplies and punish stocks and bonds.

To attain high, equity-like returns

On a total return basis, commodities, as represented by the S&P Goldman Sachs Commodity Index (S&P GSCI), have returned 9.9% per year since 1970, basically in line with the 10.2% return of S&P 500 Index.2

To participate in the new long-term secular bull market for physical commodities

Growth has created unprecedented demand for oil, coal, iron ore, copper, and many other commodities to support manufacturing and infrastructure development. This demand shows no sign of abating and is not limited to just China and India as many other nations are also consuming natural resources at a fast pace. Commodity producers are ill equipped to meet this increased demand as they failed to improve their production capabilities during the two prior decades of weak commodity prices. It is now harder and costlier to find and produce many of these materials than ever before.

Various Approaches to Commodity Investing

Exposure to commodities as an asset class can be achieved through a variety of active or passive strategies. Most institutional investors take a passive approach, utilizing unleveraged commodity indices to offset risks in their portfolios from investments in other asset classes, such as equities. For these investors, exposure to a variety of commodity indices and sub-indices can be achieved by investing in ETFs, ETNs, over-the-counter (OTC) swaps and other structured products designed to track the performance of a specific commodities index. Larger institutions can also choose to run their own in-house, active strategy by utilizing fundamental research to strategically set individual commodity weights and employ long-short pair trades.

Presently, there are over half a dozen leading commodity indices to choose from, although the S&P GSCI and the Dow Jones-UBS Commodity Index (DJ-UBS) are the most widely used by institutional investors. The S&P GSCI was first published in 1991, but historical price data was combined with its rules-based methodology to create a performance record that dates back to 1970, the longest return history among commodity indices. The DJ-UBS was created in 1998 and has a backfilled performance record that starts in 1991. Both benchmarks represent unleveraged, long-only investments in commodity futures near to expiration with the collateral being invested in cash instruments. Their mechanics for buying and rolling futures are also similar. The differences between the two arise from composition methodology.

The S&P GSCI represents 24 commodities whose weights are based on world production quantities over the last five years. The DJ-UBS represents 19 commodities whose weights are two-thirds based on liquidity and one third based on world production values. In addition, the minimum allowable weight for any one commodity is 2% and no more than 33% may be invested in any one group of commodities. These methodologies lead to the S&P GSCI being approximately 70% weighted in energy, versus 33% for the DJ-UBS. The next largest sectors within the two benchmarks are grains and industrial metals.

Three Sources of Returns

Since commodities do not pay dividend or coupon income, how have commodity indices managed to produce attractive equity-like returns, particularly during the 1980s and 1990s when commodity prices were more range bound? The answer lies in the three sources of returns from a long-only fully collateralized index strategy, which include spot price return, the interest earned on the collateral, and the roll return or roll yield.

Spot Price Return

Spot-price appreciation from price fluctuations in the underlying commodities is the directional exposure to commodities that investors with a bullish outlook on the asset class are seeking. For example, if you own oil futures and the spot price jumps from $80/per barrel to $100/per barrel, the position is profitable.

Commodity Index investments are “fully-collateralized” meaning that for every desired $1 dollar in commodity futures exposure, an investor has set aside $1 dollar in cash equivalents, making the investment unleveraged. Because only a minimal cash outlay is actually needed to buy or sell futures, the rest of the principal outlay is invested in short-term instruments, such as Treasuries.

Roll Yield

Roll yield is the return generated by rolling a futures contract from month to month as that contract converges to the spot price. Unlike stocks or bonds, futures contracts expire on a monthly or quarterly basis. To maintain exposure to a basket of commodity futures, a commodity index or manager must continuously “roll” contracts forward by selling out of the expiring contracts and buying the next month’s contracts. When the expiring contract is rolled into a later month contract, this strategy earns profits when the later month contract is cheaper than the contract being sold, often called “backwardation”. But it results in losses when the forward curve is upward sloping or the later month contract is more expensive, often called “contango”.

Active Approaches to Commodity Investing

Although commodity indices have posted strong returns over the last few years, their historical volatility is similar to stocks and may be manifested by dramatic price swings. Passive long-only indices have little protection from downward price spikes as they cannot sell short.  They also make no distinction between markets trading in backwardation or contango, either on a persistent or short-term basis and cannot mitigate the negative roll yield associated with contango.

For these reasons, some institutional investors actively invest through asset managers, commodity-focused hedge funds, Commodity Trading Advisors (CTAs), or a few manage it internally through direct investments in commodity futures contracts and ETFs to complement a passive index approach and improve on the three components of total return. These investors still seek the low correlation and beta return of their preferred commodity benchmark, but are also making some active commodity bets to generate alpha.

Active managers can leverage fundamental equity expertise, attempt to forecast where prices are headed, exploit mispricings and emphasize situations that appear to provide interesting active risk opportunities. For example, active managers can implement both long and short positions to potentially capture price movement opportunities resulting from supply and demand imbalances. The active component of the strategy can help to mitigate negative roll yield when certain commodities are in contango.

In declining or volatile commodity markets, the high liquidity of most futures contracts may provide active investors with the flexibility to increase cash and more nimbly exit positions to protect capital, potentially offsetting the limitations of long-only index strategies.

Because commodity market participants include producers and consumers, in addition to investors, we believe the potential for identifying alpha opportunities can be greater than in other more efficient markets. While a passive approach to commodity investing is likely to generate beta in a long-term secular bull market, we believe that a component of active exposure to the asset class can provide tactical opportunities to derive excess returns from market inefficiencies.

Endnotes:

1 Barclays Capital News Releases March 2, 2006, February 24, 2010
2 Source: Bloomberg©. For the period 1/30/70 – 03/31/10.

Nick Koutsoftas is senior vice-president and portfolio manager, Ben Ross is vice-president and portfolio manager and Geoff Fila is vice-president and research analysts with GE Asset Management

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