Commodity Alpha in Tough Times

Active approaches help battle inflation risk.

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story_images_oil_gas_miningInstitutional interest in commodity and natural resource investments has increased substantially since 2000. According to the Financial Times, large pension funds such as ABP, the BT Pension Scheme, Fonds de Réserve pour les Retraites, the Teacher Retirement System of Texas, and the Teachers Retirement System of the State of Illinois started making allocations to commodities around this time.

Investors like their potential to add uncorrelated performance and protect the value of investments during inflationary environments. They also see the prospect of participating in a “secular bull run” originating from aging resource production infrastructure and burgeoning demand from emerging economies in Asia have captured the attention of investors and financial media alike. At the same time, swollen central bank balance sheets and anxiety over the debasement of fiat currencies and inflation have also contributed to institutional investor interest in commodities.

However, institutions have been slow to venture in to commodities despite the significant increase in media attention and coverage. The Financial Times, Pensions & Investments, and other sources seem to suggest that among those institutions that have invested in commodities, allocations range from less than one per cent to slightly more than four per cent on average.

Although institutional allocations to commodities are currently small, many pension and endowment fund managers have increased or plan to increase their allocations in the near future. Notably, the number of institutional mandates won by commodities managers has increased steadily during recent years, from seven in 2005, to 19 in 2008, to 25 in 2009, according to management consultant Eager, Davis & Holmes LLC, the Financial Times stated.

The most recent FTfm/Towers Watson survey of alternative investment managers looking after pension fund money revealed that the level of pension fund assets accounted for by commodities managers among the top 100 managers tripled in 2009, and the number of commodities managers in the top 100 increased from one in 2008 to five in 2009. The Financial Times also pointed to a recent survey of U.S., Canadian, and European institutional investors conducted by search consultant bfinance which stated that 21 per cent of respondents plan to increase their target allocation to commodities in the next three years and no respondents planned to decrease their target allocation.

Historically, investors have generally preferred to access commodity exposure in their portfolios through commodity “beta.” There is no consensus on what commodity beta precisely is, or if commodity beta exists at all, but for the purpose of this report, commodity beta is defined as long exposure to one of the passive long-only commodity indices such as the S&P Goldman Sachs Commodity Index (“S&P GSCI”), Dow Jones UBS Commodity Index, Rogers International Commodity Index (“RICI”), or others.

While passive long-only commodity indices provide investors with inexpensive long exposure to natural resources, they must be aware of substantial disadvantages to the beta approach. Most notably, long-only indices can be extremely volatile and are susceptible to large losses. The S&P GSCI, DJ UBS Commodity Index, and RICI all experienced peak-to-valley losses of 50 to 70 per cent during the financial crisis of 2008. Further, passive long-only indices may not offer balanced exposure to different commodity sectors.

For example, the S&P GSCI allocates over 70 per cent of the index to energy, and the other indices tend to be lopsided as well. Last, negative roll yield in commodity futures (accessing commodity exposure through physical commodities tends to be prohibitively expensive and problematic due to storage and other reasons) in contango can also be detrimental to the performance of the passive long-only indices. Despite these weaknesses, passive long-only commodity index investing appears to have been relatively commonplace among institutional investors who typically turned to total return swaps, exchange traded funds or notes, index futures, or futures-based indices.

Institutional investors wishing to avoid the inherent shortcomings of passive commodity indices may instead access the natural resources space through commodity “alpha,” which for the purposes of this article, is defined as actively managed exposure to natural resources with the flexibility to take long, short, neutral, or spread positions. Examples include natural resources-focused hedge funds and commodity trading advisors, natural resources fund of funds and multi-manager portfolios, and actively-managed or semi-passive natural resource index products.

Commodity alpha offers investors the potential benefits of active management, namely the ability to take advantage of opportunities on both the long and short side, as well as the ability to deploy relative value or niche strategies. These qualities often result in uncorrelated performance which can enhance portfolio diversification and help to dampen volatility. Alpha investments also typically actively manage risk in response to changing market conditions, so their volatility and susceptibility to large losses tend to be better controlled than for the passive long-only indices.

The potential benefits of commodity alpha do come with additional costs. Alpha managers typically charge higher fees, and may only partially capture the upside of passive long-only indices, limiting the investor’s ability to participate to the fullest extent possible in commodity bull markets. It may also be difficult to understand the timing of, reasons for and degree to which different alpha managers or investments capitalize on price moves. The investor is also subject to the additional costs of manager sourcing, selection, due diligence and monitoring, all of which require specialized expertise.

Investors seeking a more balanced approach can combine commodity alpha and beta investments to meet their own objectives or risk and return preferences. This can be done by focusing on sector specialists, creating different blends using commodity beta and alpha investments, or by building structured products, all of which may have customized correlation or risk properties relative to the passive long-only indices. An investor could, for instance, create a portfolio that offers high correlation to one of the passive long-only indices but with lower risk.

Commodity alpha investments offer an alternative to beta plays using passive long-only indices to gain commodity exposure, and one which appears to be gaining increasing acceptance among institutional investors. Pensions & Investments stated that institutional investors are abandoning index products in favor of active and hedge fund strategies and that those new to commodity investing are skipping over index strategies entirely and accessing the space through alpha strategies.

Actively managed commodity alpha strategies provide investors with exposure to the asset class with the added benefits of opportunistic trading from both the long and short side, active risk management, and the potential for decreased volatility and losses. The allure of additional diversification alpha investments may offer, and the value that they can add through active management, may make them a compelling way to access the asset class.

Ranjan Bhaduri, PhD, is chief research officer at AlphaMetrix Alternative Investment Advisors. rbhaduri@alphametrix.com.

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