By Shaun Port
This article previously appeared on IndexUniverse.com
Passive investment has gained broad acceptance as a valid investment choice across a range of asset classes, notably equities and bonds in developed markets. Are the benefits of passive investments transferable to commodities?
Providers of index-tracking products cite several key features namely low fees, simplicity and liquidity.
Given the 30% decline in commodity markets in the fourth quarter of 2008, are these benefits worth paying that much for? This note looks at whether passive investing is applicable to commodities and whether active managers are a better alternative.
Passive Investments Use Fixed Weights To The Largest Traded Commodities
Equity indices set weights based on the largest companies – in essence the ‘winners’. In bonds, weights are based on large issuers of debt. For commodity indices, weights are set based on commodities with the largest trading volume or greatest consumption in the global economy. Passive indices set weights generally at the start of the year and drift with price changes through the year.
This means that investors are tied to significant exposures to the commodities with the highest use. This typically leads to excessive exposure to energy commodities. Even in the DJUBS index where the exposure to energy is capped to provide a more balanced exposure, just seven commodities account for 61% of the index (crude oil, natural gas, gold, copper, aluminum, corn and soybeans). This means that investors are ‘locked in’ to the returns of just these major commodities. Sugar, one of the best performing commodities this year, has only a 3% weight in the DJ UBS index.
Commodity Indices Are Narrowly Focused
Passive indices are narrowly focused. The DJUBS index, a commonly used index by trackers, contains 19 commodities. We aim to gain exposure to at least 50 commodities.
To give some examples of commodities missed out by the DJUBS index which we believe are important are:
- Energy: ethanol, coal, electricity, uranium, diesel, kerosene, natural gas liquids, plastics
- Metals: aluminum alloy, lead, tin, platinum, palladium, steel
- Agriculturals: rice, barley, canola, oats, paper, wool, lumber, rubber, natural oils (palm, coconut, sunflower), cocoa, rubber
- Markets connected to commodities: shipping rates, weather and emissions
Moreover, the major indices focus on US-traded commodity futures 16 of the 19 commodity futures tracked in the DJ UBS index are based on US exchange contracts. We look to gain exposure to commodities across different regional commodity exchanges, rather than focus solely on the US exchanges.
We believe that this approach to broadening the commodity universe provides more opportunities to boost returns but also to lower risk. Unlike equity and bond markets, commodities have low correlations with one another. Simply put, there is little reason for lead prices to be correlated to soybeans, which cannot be said for major companies within the large capitalisation equity indices.
Commodity Indices Use The Commodity Future Nearest To Delivery
This means that passive indices may miss opportunities when current prices are stable but longer-dated prices are rising. If we take aluminum as an example, prices for delivery in the longer term (more than two years ahead) have risen faster (or fallen less) than short-term prices (for delivery in 3 months) in 53% of months since 1993.[ii] In some cases, while current demand may be amply covered by existing stocks, the balance between longterm supply and demand may be changing significantly, which pushes up longer dated prices. Passive indices will miss these opportunities.
Most Trackers Are Backed By Notes, Not Commodity Futures
Most commodity trackers are backed by swaps and medium term notes, rather than commodity futures, exposing investors to a degree of counterparty risk (such as a bank). However, some commodities backed by physical holdings (with low storage costs) can work well in passive investments. At present, this only applies to precious metals such as gold and silver.
Passive Investment The Right Choice For A Long-Term Allocation To Commodities?
To us, the expectation of a longterm structural increase in demand for commodities from emerging economies means that commodities should be a longterm investment in an investment portfolio – and not one based on market timing. Commodities often benefit from shocks (such as supply disruptions) and then trade in ranges, so making short-term ‘bets’ on individual commodities is difficult to time. Our view is that commodity investment should not take an ‘on/off’ approach.
When Is The Right Time To Buy A Commodity Tracker?
If investors do want to take a tactical position in commodities, based on whether it is the right point in the economic cycle to buy commodities, they also need to assess whether the ‘shape’ of the futures curve is to their advantage or not.
By this we mean whether prices for delivery in the future are higher or lower than prices for delivery in the near term. If prices for longer-dated contracts are higher than the closest to deliver, there is an implicit cost to managing a commodity futures investment.
This means that passive trackers may not be low cost on the whole. While management charges are low at typically around 0.50% per annum, investors need to consider the possible ‘cost’ or hurdle from the ‘roll yield’ before investing.
To explain in more detail, commodity index returns are based on two sources – the return from a commodity futures portfolio and the yield on collateral held to back up those futures positions (such as US Treasury Bills). In turn, the total return of a commodity future can be thought of in two parts – the return from changes in ‘spot’ prices (i.e., near term immediate delivery) and the ‘roll yield’.
Prior to the expiry of a commodity future – when the commodity would be delivered or cash paid to a holder – the holding is ‘rolled’ to the next available futures contract. Often, commodity indices roll on a specific date.[iii] For example, if the contract for January delivery of crude oil is about to expire (on 23 December) the investment is ‘rolled’ onto the February contract.
However, if the price of the longer-term contract has a higher price, this may imply a cost as prices for near-term delivery are lower. As the time moves on, the nearby future falls in value towards the ‘spot’ price.
The cost of buying a nearby commodity future which falls in value as it nears expiry is known as a negative ‘roll yield’.
For some commodities, the roll yield is very significant. In fact, for 17[iv] out of the 19 commodities in the DJUBS Commodity index, prices one year ahead are higher than the nearby futures contract – on average the forward price is currently 9.0% higher than current nearby futures.[v]
This means that the ‘roll yield’ can imply a significant hurdle to returns as ‘spot’ commodity prices need to rise by more than 9.0% to compensate for the negative roll yield before investors gain a positive return.[vi] Obviously the degree of the premium in forward prices can change (or reverse) but this ‘cost’ is relatively common. We estimate that the roll yield has been a drag to returns for passive investors in 11 of the past 12 years, approximately an average of 8.7% per annum.[vii]
Commodity Returns Exhibit Seasonal Patterns
For most commodities, passive investment is problematic due to the uncertainty of the impact of the roll yield. This is particularly true of commodities that exhibit distinct seasonal patterns. Examples are natural gas, with heating and cooling demand seasons (see Figure 1) and agricultural commodities (seasonal plantings and harvesting).
Our research shows that there is pronounced seasonality in many agricultural commodities, with returns from agricultural commodity futures particularly negative over June to September for grains, July to August for beans, and February and April for tropicals (cocoa, coffee, sugar).[viii] With a passive approach to commodity investing, such impacts are not considered.
Figure 1. Natural Gas Future Prices (Henry Hub) By Contract Expiry Date
(Source: Bloomberg as at 27 November 2009)
Commodities Are Volatile
On an individual basis commodities are volatile. For example, natural gas, which is 12% of the DJUBS Commodity index, has had a daily trading range of 5.0% since 2000 – on average. [ix] As a whole, a commodities index basket has historically shown a similar risk level to that of developed equity markets. Such volatility may make passive commodity investment a difficult choice for lower risk portfolios and may mean that more conservative investors miss out on the diversification benefit commodities can bring to a bond-focused investment portfolio.
No Currency-Hedged Class
Few passive investments are available with foreign currency exposure ‘hedged’ back to local (home) currencies to substantially reduce the risk of foreign currency investment. Buying a dollar-based passive (index) investment means you are essentially taking three views – (a) that the spot price is going to rise (b) the shape of the futures curve will be in your favour or not overwhelm the rise in spot prices and finally (c) that the dollar will not depreciate against your home currency. You are implicitly betting that the dollar will strengthen against sterling.
In many ways, passive investments are a missed opportunity in commodity investing. So what do active commodity managers do differently?
Take Active Positions On Commodities
Managers will buy those commodities with the best fundamentals, not those that are traded in the most volume. Individual commodities have very different supply and demand dynamics. In many occasions, rising energy costs do not mean that industrial metals prices should be increasing or vice versa.
Moreover, many active managers will go ‘short’ commodities – to benefit from falling prices. This allows managers to exploit changes in the demand cycle when stock levels have become too high or demand is faltering. Many active managers who trade commodities ‘long’ and ‘short’ made positive returns in the fourth quarter of 2008 while the market index lost 30.0%.[x]
Exploit The Wide Commodity Universe And The Whole Of The Futures Curve
As we mentioned earlier, commodity investment should not be limited to 20 or so commodities. Opportunities abound in trading commodity futures on major futures exchanges across the world, not just the United States.
Active managers can trade in longer dated futures to exploit longer-term demand and supply dynamics and to lessen the impact of the roll yield when futures curves are upward sloping.
Trade Commodities On A Relative Value Basis
Active managers do not solely depend on prices going up. As well as finding commodities to ‘go short’ when fundamental factors warrant such an approach, many managers employ a ‘relative value’ approach.
Examples of such are based on quality grades (for example West Texas versus Brent oil), regions (North America versus Asia), intra-commodity (soybean meal versus soybean oil), time (far ahead prices versus short term) and combinations of commodities (for example coal plus emissions versus natural gas). In many cases, prices of very similar commodities can become detached.
Such examples are that power (electricity) prices can diverge from the underlying generators of energy like natural gas, coal and hydropower, and diverge across regions due the lack of a global mechanism for trading power. Although some commodities have similar drivers in certain circumstances – e.g., corn based ethanol versus gasoline prices – this is not always the case.
By employing a more diverse set of commodities and strategies, together with sophisticated risk management systems, active managers can help avoid some of the sharp declines in prices and reduce the volatility of commodity investments.
The Fitzwilliam Commodity Plus fund takes an active approach to commodity investment for professional investors. Since inception in February 2006 to October 2009 the Fitzwilliam Commodity Plus fund has outperformed the DJ-UBS total return index by 45.4% net of fees, with a standard deviation of 9.6% versus 22.1% for the DJ-UBS. Fitzwilliam Commodity Plus’ correlation with broad equity and bond markets is -0.02 and -0.06 compared to +0.47 and +0.40 for the DJ-UBS index, showing the strong diversification benefit of an active approach to commodity investment.[xi]
i. DJ-UBS Total Return Commodity index
ii. Data from July 1993 to October 2009, longer dated prices outperformed in 104 months out of 196.
iii. The process is slightly different for each commodity index. For the DJ-UBS index the roll is implemented over the fifth to ninth business day each the month, gradually increasing the weighting of the new contract to 100%.
iv. As at close of 24 November 2009 only two commodities – Sugar and Soybeans - had a forward price lower than nearby futures (known as ‘backwardation’). In Soybeans the level of backwardation was negligible (-0.6%).
v. Based on new weights to be implemented in January 2010. Data as at 24 November 2009. Calculation assumes that the shape of the futures curve remains unchanged.
vi. Assuming the return from collateral is negligible, which it is at present with interest rates near zero.
vii. Our calculation represents an approximation of the ‘cost’ of the roll yield based on data from the GSCI Light Energy index. In agricultural commodities, the roll yield has been a cost in each of year, with an approximate cost averaging - 12.4%.
viii. Data used is monthly returns from the GSCI Excess return index from 1970 to October 2009 and so excludes the impact of collateral yield.
ix. Calculated as the daily range of the NYMEX Henry-Hub nearest to deliver contract over 2000 to end October 2009. In February 2003, over a five day period the 1st contract ranged between $5.87 and $11.9. Two weeks later the price was back close to $5.
x. A commonly used passive index in the UK lost significantly more than the 30% decline of the index being tracked.
xi. Based on monthly net return data for the US dollar class. Indices used are DJ-UBS Total Return Index, MSCI World Net, JPMorgan Global Aggregate bond index.
This commentary has been produced by Fitzwilliam Asset Management Limited. Fitzwilliam Asset Management Limited is authorised and regulated by the Financial Services Authority. Fitzwilliam Asset Management Limited is registered in England and Wales No 06236394. The registered office is 55 Baker Street, London W1U 7EU.
Copyright © December 2009. Fitzwilliam Asset Management Limited. All rights reserved.
Shaun Port is chief investment officer with Fitzwilliam Asset Management in London.