When Commodities Confound
I'll have my investment con tango.
May 11, 2011
The big investment story this year has been the rise – and choppy volatility – of commodities. Of course, one can seek reasons in the natural rhythms of the weather – floods and frightful droughts, tsunamis, tornadoes and torrential rains. But there is also the speculative interest.
Just days before silver futures collapsed – or perhaps corrected – The New York Times ran a piece on how folks were climbing into their attics to find Grandma's tea set to pawn. Perhaps a little late in the game. Or maybe not.
New margin requirements on silver futures may – or may not have – tamed that impulse. Silver dropped from from its highs even before The New York Times article was published – call it the front-page effect: when an investment becomes mainstream news, it's likely to have topped (much the same as when a trendy restaurant gets top reviews, it's too late to experience the elements that brought that restaurant to the top).
There are taste-makers, after all (the folks who somehow establish the tipping point). Perhaps the same is true with traded commodities: folks who set margin requirements, in this instance, CME – the Chicago Mercantile Exchange who upped the collateral, in a series of steps, by 84%.. That's a fair amount of cold water (itself not yet a tradable commodity) poured on day-traders.
But pension plans aren't interested in the daily or monthly gyrations of different commodities. They are looking at the long-demand in a globalizing world where even scrap metal is transported from sea to sea.
Nevertheless, the gyrations of commodity investments make for two different strategies: trend-following or buy and hold (or hope).
The trend following universe consists of commodity trading advisors. They are expected to deliver uncorrelated performance. In a recent note from the EDHEC Risk Institute, they do – and they don't.
"Much has been written about the low correlation between managed futures strategies and the S&P 500. However, over certain periods, the correlation between the two can be quite high….[we] find CTA returns appear to be independent of S&P 500 performance irrespective of correlation levels. Second, when correlations between the two indices are high, the S&P 500 exhibits significant positive performance."
So managed futures may not be an all-weather strategy for diversification. What is?
In another white paper, GE Asset Management argues: "For more than a decade, institutional investors have increasingly sought broad commodities exposure to improve portfolio diversification, help protect against unexpected inflation, and participate in the bullish long-term outlook for the asset class. Although passive index-linked commodity strategies traditionally have been a popular way to gain exposure to the asset class, some institutional investors are moving toward active management for their commodity allocations."
One reason is roll yield. Here's the effect: "Over longer periods of time, commodity index strategies have provided high equity-like returns, portfolio diversification benefits, and protection against future inflation. Over the last several years, however, the investment returns of passive strategies have been significantly eroded by negative roll yield. In 2009, for example, the spot price of West Texas Intermediate (WTI) crude oil appreciated by 78%, yet a passive commodity investor realized just a 7% return after accumulating roll losses due to the upward sloping forward curve (contango)."
Contango happens when the current three-month contract on a commodity trades for less than the next three-month contract. It is a danger that many commodity ETFs face. To maintain exposure as the futures contract rolls over, the ETF may be buying high (and selling low). The mechanism for getting access to a market confounds the capture of the return expected from that commodity market.
Note Nick Koutsoftas and Ben Ross, managers at GEAM:
"The total returns generated from investing in commodities come from three sources: 1) the spot return, or simply the change in market price of the physical commodity; 2) the collateral yield, or the interest made on the cash held in the account; and, 3) the roll return or roll yield. Roll yield is derived from the price differential of rolling expiring contracts into longer-dated contracts to avoid delivery and maintain exposure to each individual market."
The mechanics of futures – and apart from having a gold bar in your pocket or a loaf of bread in your bag, it's hard to get exposure to commodities otherwise – can be quite puzzling for long-only investors, they write:
"As mentioned earlier, negative roll yield occurs as a result of contangoed markets and has become a significant drawback for passive commodity index strategies in recent years. As a result, their investment returns have sometimes lagged spot commodity prices. For example, the most popular commodity index, the S&P GSCI Index, accumulated roll losses each year from 2005 through 2010…. Over this 6-year period, a passive long-only strategy tracking the S&P GSCI (cumulative total return) would have lost approximately 21.7% despite spot prices being up 65.4%."
As the saying goes: don't bet the farm on spot prices. But the land is strong and has potential. It just may take a while – and a bit of strategy — to realize that value.