With so much interest in commodities, we thought this might be a good time to revisit the rationale for so-called managed futures funds. But as Keith Black, CAIA, of consultant Ennis Knupp + Associates says, commodity investing is about a lot more than buying and holding commodities in hopes that the Chinese continue to buy new cars.
The Case for Commodities
Special to AllAboutAlpha.com by: Keith Black, CFA, CAIA, Associate, Ennis Knupp + Associates
Over the last several years, institutional investors have more than doubled their allocation (to over $200 billion), to financial products whose returns are linked to those of commodity indices. Commodities may be attractive due to: the low correlation between their returns and those of other asset classes, the high correlation of commodities returns with unexpected inflation, and the rising demand for commodities from fast-growing emerging markets countries, such as China and India.
In fact, when you look at the performance of these commodity indices during the best and worst quarters for the Wilshire 5000 (and quintiles in between), you can see that they have produced modestly positive returns in almost all quintiles. In fact, the correlation between commodity indices and other major asset classes is generally below 0.2 (see chart below):
Commodity Beta via Equities
While these indices provide a simple method of gaining commodity exposure, one could always implement their views on commodity prices by investing in equity securities. The prices of these stocks may be somewhat correlated with those of commodity futures. Metals firms include Alcoa and Anglo American, while agricultural firms include Archer Daniels Midland. In the energy sector, stocks such as Exxon-Mobil, Chevron and ConocoPhillips may be used as a crude oil proxy.
But the problem is that existing exposure to equities means commodity-linked equities may not be the best way to express a view on commodity prices alone. To make matters worse, commodity stocks are likely to underperform commodity futures during times of high inflation. When inflation and commodity prices rise, stock prices typically decline, meaning an investor may not actually earn the anticipated return.
The bottom line is that commodity futures are a more direct way to earn the diversifying benefits of commodity investments (especially metals, energy and agricultural commodities) without increasing the stock market risk of the overall portfolio.
Sources of Return
Part of the reason for this is that the total return to a commodity futures index consists of three components: spot return, roll return and yield. The spot return is the return to an investment in physical commodities. The roll return is earned in the process of passively trading (rolling) futures contracts as they mature and must be replaced. The yield is the interest earned on a short-term fixed income investment that is pledged to the futures exchange in order to maintain the collateral required to back the futures investments. As you can see from the table below, the annualized return of the S&P GSCI can be attributed to each of these three components.
But commodity price increases have not exceeded the rate of inflation over long periods of time. As new natural resources are discovered, production technologies improve and research advances in areas such as crop engineering and alternative energy, commodity prices tend to decline in real (after-inflation) terms. So how could commodities futures have offered a total return rivalling that of equities since 1970 if the ownership of physical commodities does not offer a return that exceeds inflation? The answer is in the roll return and the collateral yield, as shown in the chart below.
The roll return and collateral yield can only be earned when investing in commodity futures. The return to commodity futures investments has significantly exceeded that of a direct (spot) investment in commodities over the last 37 years. This is because futures contracts have a finite life. Commodity index investors normally invest in the contract nearest to expiration, which is typically less than three months. In order to maintain a consistent exposure to a given commodity, the investor must purchase a new contract at or before the time of expiration of the current contract. The roll return to a commodity futures investment is earned when the futures position is rolled from the current contract to a later-dated contract.
When a futures curve is in backwardation the investor buys a contract at a lower price, say $70 for the June contract, and sells it at a higher price of $75 when prices rise as the contract nears expiration. Should the curve retain the same shape, with the front month futures trading at a premium to later-dated contracts, the investor will earn a positive roll return as time passes and the June contract becomes the premium-priced front month contract.
Conversely, an upward-sloping futures curve is one in which later-dated contracts trade at a higher price than the current futures contract (contango). Contango markets are undesirable for a commodity futures investor as the return to rolling futures contracts is negative.
The secret behind commodity futures: roll return
Futures markets are likely to remain in backwardation when producers of a commodity desire to hedge the sales price of their commodity production. A positive roll return can be earned when producers view futures markets as insurance and are willing to sell futures at a low price in order to insure against a decline in the commodity price.
The market will continue to offer a positive roll return as long as the demand for producers to sell is larger than the demand from investors or speculators to purchase those contracts. However, over the last two years, investors have funnelled over $50 billion into indexed futures investments and a number of exchange traded funds (ETFs) were launched that invest in oil, gold and silver futures.
The result of this additional demand for investments in commodity futures has served to move many futures markets into contango. The potential to experience a negative roll yield during certain market conditions is one reason why EnnisKnupp does not recommend passive investment in products that track commodity futures indices for most clients. Another reason is that over time, commodity investments have been quite volatile and the returns don’t fit well into a traditional asset valuation framework, such as the Capital Asset Pricing Model (CAPM). Variables such as political strife and weather can have a significant impact on both long-run and short-run commodity prices.
Actively Managed Commodities Funds
Given the drawbacks of commodity-linked equities and commodity futures indices, where does this leave us? It turns out that active management of roll dates and index selection can add significant value in commodity futures markets. For example, in a case where the entire futures curve for a given commodity is in contango, an active manager can choose to reduce or eliminate exposure to that commodity.
In addition, managed futures funds (CTAs) allocate about 25 percent of their assets to commodity markets and 75 percent of their assets to financial markets, including currencies and futures on equity indices, interest rates and bond prices.
Flexibility and the addition of non-commodity futures results in a relatively low correlation between managed futures and (passive) futures indices. Global macro hedge funds, which often trade commodity futures also have a low correlation to futures indices as the table below shows.
Commodity investing is about a lot more than simply hoping commodities will rise over time. After all, the GSCI spot index earned an annual return of only 4.0 percent since 1970, cash returned 5.8 percent and CPI increased by 4.6 percent per year over the same time period. But with so many factors influencing price movements (roll, demand/supply etc.), active commodity management can provide real alpha opportunities.
Ennis Knupp + Associates does not recommend strategic allocations to commodity futures investments. However, we do believe that commodities have a role in the portfolio of plans that value the historic tendency of commodity futures investments to have a higher correlation to inflation and a lower correlation to traditional stock and bond investments.
– Keith Black, June, 2008
The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.
Editor’s Note: Keith is the author of a more detailed paper on commodities and timberland in institutional portfolios available here at Ennis Knupp + Associates’ website.