In a world where the pricing of risk seems to be selective at best, risk seekers have been scouring the planet to come up with outsized return and portfolio diversification opportunities.
For both aims, commodities at first seemed like a darling in the post-bubble world following 2000. Growth from emerging markets was booming, creating a huge demand for a variety of resources, oil markets became a focal point not only of debate about supply-demand imbalances, but of much geopolitical speculation, and the wave of money created by sustained low interest rates in the past few years found an asset class that not only offered huge returns, but which was alleged to be decorrelated with equities.
But questions abound on the strategic opportunity for commodities investing. Do the rewards, in fact, justify the risks? The arguments supporting investing in commodities as an asset class essentially follow those of investing in other asset classes: namely, the desire to seek returns and manage risks. Thus, there is a performance and diversification characteristic.
In their paper: ‘Facts and Fantasies about Commodity Futures’ (2004), Gary Gorton of the University of Pennsylvania and K Geert Rouwenhorst of the Yale School of Management analysed series of historical data from 1959 to 2004.
As their analysis illustrates (figure 1), historically commodity futures have delivered equity-like returns, although with slightly less volatility. But is is in examining the correlations that commodities have with other asset classes that many portfolio managers have been seduced.
Figures 2 and 3 show the short- and long-term correlations between the principal asset classes of stocks, bonds, and equities, as well as inflation versus these assets. In the long-term, commodities are negatively
correlated with both stocks and bonds, although more strongly so with the former than the latter. Gorton and Rouwenhorst say the negative correlation is due in large part to different behaviour over the business cycle.
And it is in citing such historical performance and diversification benefits that Douglas Hepworth, director of research at Gresham Investment Management, a NY-based long-only investment manager, favours a diversified portfolio of commodities. With a 20-plus-year audited track record in commodity investing, Gresham’s philosophy is that asset allocation decisions are the most important.
“The signal to noise ratio in individual commodities is too low - but in a portfolio context, signals begin to rise,” explains Hepworth.
In other words, adding a single commodity is like introducing a coin tossing machine into your portfolio, but adding a diversified set of commodities is strategically beneficial.
Dan McAlister, a hedge fund analyst for Ermitage, a $2.7bn (€2bn) Jersey-based advisory service that specialises in hedge fund investments, points out that commodities had been largely neglected prior to 2000 - for the better part of 25 years.
“Commodities had stagnated for a long time, but after 2000, people began looking at all kinds of alternatives to complement traditional equity and bond investments,” says McAllister. Ermitage runs a $70m fund of hedge funds that invests not only in traders of commodity futures but also managers trading equities on resource companies, as well as even those dealing in carbon emissions and freight derivatives. There are many ways to access this asset class, and everyone seems to be looking at how do it. But that choice aside, McAllister sees ample opportunity in the commodities space.
“In my opinion, commodities are here to stay - they will not disappear as an asset class like they did more than twenty years ago,” says McAllister.
here are clearly two different implicit arguments tied up in McAllister’s claim. The first is the so-called wall of money argument, which contends that recent soaring prices for commodities are being driven by money flows. And the second is the so-called supercycle argument, which holds that supply and demand imbalances for the underlying products - oil, gas, corn, pork bellies, coffee, and so on - justify continued outperformance. Here the discussion gets interesting. “Commodities investing - what does that mean?” asks David Mooney, who runs a commodities fund-of-fund for New Finance Capital, a UK-based fund-of-hedge fund and advisory service.
What Mooney means is that although commodities might have attracted a lot of attention, it is erroneous to assume to that these markets behave like other asset classes.
“I mean, I can drink coffee, but can I really invest in coffee?” Mooney posits. Which raises some interesting, and rather uncomfortable questions.
Assets, by definition, are items of economic value that can be converted into cash. But unlike investing in a company, for example, which through certain decision management can create surplus value, commodities - according to many - are relegated to mean reversion, meaning that in the long-term they should not markedly outperform inflation because supply eventually catches up with demand and price spikes result in demand destruction. And also unlike many other assets, commodities do not produce cash flows, making the measurement of risk problematic.
Mooney notes that it is important to keep in mind what we are talking about when using certain definitions. Commodities, for many mean commodity futures, or claims on the physical assets at a future date.
Because futures have a fixed expiry date, contracts must be rolled over each month, either a costly endeavour that slowly eats away at returns or a nice way to pick up consistent yield on a longer-term price view.
John Maynard Keynes called this the Theory of Normal Backwardation, whereby backwardation refers to spot contracts having a higher price than future contracts - in other words, the term structure of the forward curve is naturally downward sloping. So, investors buy forward at a lower price spread to spot which slowly increases to spot price as the contract approaches maturity, allowing returns to accrue to the holder.
Keynes held that the price differential between the futures contract and the future spot price of the underlying was the risk premium that compensated investors for taking on the unit of risk. But not everyone agrees with this formulation of risk premia.
In a paper published by EDHEC Risk and Asset Management Centre in France, ‘Conditional Risk Premia and Correlations in Commodity Futures Markets’, James Chong of California State University, Northridge, and Joëlle Miffre of EDHEC Business School attempted to test the theory of normal backwardation.
The authors show that investors in commodity futures earned significant risk premia over the period 1979-2004 (which applies to 19 of the 21 commodity futures markets studied), a result that strongly supports the notion that risk transfers occur in commodity futures markets between hedgers and speculators.
In other words, a backwardated market would suggest that hedgers are net short, such that going long would allow the collection of the risk premium. The opposite occurs in what is considered a contangoed market, where futures contracts are more expensive than future spot prices. If so, investors should take short positions to earn positive risk premia.
The authors note that caution should be used in extrapolating results - read: post-2004. They found that the risk premia of 12 commodity futures markets were negative (contango) over the period 1979-2004, while the risk premia of seven commodity futures were positive (backwardation). Moreover, six commodity futures markets out of the 21 total switched from contango over the period 1979-1991 to normal backwardation over the period 1992-2004.
Where some debate its impact, there is no doubt that in recent years a wall of money has been chasing commodity investments, the lion’s share of which has been funnelled into indices such as the GSCI, DowJones-AIG Index, and the Rogers Raw Materials Index.
However, Arun Assumall, the London-based head of commodity investor sales for Goldman Sachs, thinks that blaming money flows alone on recent price trends is missing what’s been really happening.
Assumall says that chronic underinvestment might partly explain why investors have been lining up to gain access to the sector; he notes that on a relative money basis, more money has been invested into base metals in recent years relative to the size of the market, which together with agricultural products, have been taking index market share from energy. Where the S&P GS energy total return index has gained only about 10% in the last three years, the S&P GS base metals total return index alone has risen 200%.
According to Assumall, the strategic value of commodities is very much intact, although he notes some changes to the markets, namely the increased presence of financial players. However, he is quick to note that financial players still represent a small portion of the market. And, the physical market is what ultimately drives the futures markets.
ut do the fundamentals justify the huge run-ups in almost all commodities in the past few years?
Simon Hunt, who runs an eponymous UK and Beijing-based consulting service focused on the analysis of copper and other base metals, does not think so, claiming that the presence of financial players has changed the market dynamics of copper.
“The financial institutions will have destroyed an industrial metal, the very markets that producers will need for the new capacity coming on stream over the next five to 10 years,” says Hunt, speaking about the substitution effects that are going on with copper and aluminium. Hunt believes that the run-up in copper prices over the past few years is in no way justified by the supply and demand conditions in the market. He spends much of his time on factory floors in China and elsewhere, and China is the biggest buyer of copper to fuel its booming economy. And based on what he sees, he is admittedly scratching his head.
“The fundamentals no longer make sense,” says Hunt. “The build-up of excess capacity is going to be a big, big problem - it has to.”
Where some are quick to point out that commodities have been a neglected asset class since the 1970s, Hunt notes that there was good reason: overcapacity.
Richard Cooper, senior investment consultant for Mercer Investment Consulting based in the UK, is not sanguine about the strategic value of commodities. Cooper breaks down what typically attracts people to commodities into three components:
q Diversification benefits;
q Hedge against inflation;
q Returns.
Noting that most seem to be in agreement about the diversification benefits, and that commodities’ attraction as an inflation hedge has been largely mitigated in recent years with the increased sophistication of derivatives and other ways to hedge inflation, he focuses on returns. And he is not convinced.
“We just don’t think there is a good rationale for the return component,” says Cooper. He further breaks down returns into three components:
q Cash;
q Price changes;
q Roll yield.
Here, Cooper says that the roll yield is where the devil is hiding. “For a long time, investors were picking up an extra 200bps of returns off the roll yield in commodities - but now roll yields for many commodities are negative. We can debate why that is, but it significantly detracts from commodities’ value.” In other words, even if the roll yield is roughly flat, and over the longer-term prices should fall in real terms, consistent with long-term experience, then essentially returns are restricted to cash returns - but with significantly more risk.
Cooper also tends to think that maybe market fundamentals differ according to which commodity is in question. And this may or may not justify a roll yield. According to him, thinking intuitively, cattle might justify a positive roll yield as producers are enticed to sell forward to lock in prices. But for natural gas, he notes that it’s buyers that want to hedge, not producers - so a negative roll yield might be endemic and justified.
In the land of alternatives, Mercer tends to favour cash and alpha types of spaces, such as hedge funds. As Cooper explains, most beta opportunities tend to be rather well bought in the recent low interest rate climate.
And again, a precise definition of terms would seem crucial. Alternatives, for Mercer, are alternative sources of returns to traditional equities, rather than stand alone asset classes. Because of their low correlation to other assets, commodities are going to continue to entice institutional investors. And as liquidity increases, markets will evolve accordingly.
But as we’ve clearly seen, the past might only go so far in explaining exactly how things evolve from here.
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