Investors have debated for decades over whether active or passive strategies work better, particularly when it comes to commodities. As volatile and cyclical as commodities are, the same buy-and-hold strategies that work in stocks aren't always appropriate for hard assets, and the newest indices and funds have evolved to reflect a more active approach.
Ken Armstead is partner and CEO of Absolute Plus Management, an investment firm with two funds, the APM Hedged Global Commodity Fund and the APM Global Fund. Founded in 1999, Absolute Plus Management takes an active approach to the commodities space, using value, directional and dislocation strategies to build a bond/commodities mix that takes advantage of both assets' cycles.
Recently, associate editor Lara Crigger chatted with Armstead about his thoughts on using the active approach for commodities, including the pros and cons of the passive approach, whether we'll soon see more active commodities ETFs and if contango will persist.
Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): Most commodity funds—at least ETFs—are passive, long-only vehicles, an approach that has come under fire lately. What risks are entailed in using a long-only, passive approach to commodities?
Ken Armstead, partner/CEO, Absolute Plus Management (Armstead): Commodities tend to behave in a much-higher-volatility fashion than stocks, bonds or other things. Commodities tend to be driven by short-term supply/demand disruptions, particularly when the market clearing mechanism has to rely on price behavior, because in the short run, most commodity supply is inelastic. So to clear the market, the price has to reflect what it's worth to the marginal buyer or seller. So that's why you get such volatile outcomes over time.
But clearly there are diversification benefits to owning commodities. And the way we think active managers can set themselves apart from passive indexes is by ameliorating the downside risk associated with owning commodities. For the active manager, there are a number of constructs that seem to be available for extracting returns.
Crigger: How is your approach to commodities different than others?
Armstead: We understand there are some basic macro constructs that should hold fairly true over market cycles, such as high real GDP, higher commodity demand, or higher growth demand, and so on.
In the construct of our approach, the idea is that interest rate cycles and commodity cycles tend to be countercyclical, anti-correlated to the degree that you can marry right-tail-skewed, anti-correlated return outcomes that give you a better overall portfolio benefit. Thus, we historically have married active investment processes in bonds with active investment processes in commodities. And thus we see a very different payoff than you would see from a passive index.
Crigger: In fact, your Hedged Global Commodity Fund managed to stay afloat during the big commodities crash in 2008, even as passive indexes like the DJ-UBS and GSCI fell. Why is that?
Armstead: Part of it is in how we manage our risk, which gets back to the idea of ameliorating the downside excursions. Additionally, because we own bonds on the other side, we get benefit from the countercyclicality of those outcomes. 2008 was kind of interesting, because we made most of our money in commodities in the first half, and most of our money in bonds in the second half.
Crigger: Your focus is on the institutional investor, but can the active approach also benefit the retail investor?
Armstead: I think it can be a benefit. Typically the access there could be perhaps through some sort of platform structure. I know some of the wire houses have accessible manager exposure through various platform structures, or the managed account platforms that have developed over the past few years.
Crigger: What about ETFs? Will active commodity ETFs become a viable alternative?
Armstead: Those are coming. I'm fairly confident there will be macro commodity ETFs, where managers such as ourselves get bundled into a structure that looks like an ETF. I expect that over the next few years, that will become a part of the accessible portfolio alternatives for retail investors.
Crigger: The common debate out there is over which works better: passive vs. active? Certainly there have been plenty of studies demonstrating that passive index investors tend to outperform active managers.
Armstead: I would take issue with that.
Crigger: OK. Why?
Armstead: Well, let's just walk through it and think about it. If I've got a passive index, and I'm down 40 percent in a year, you can do the math and figure out how much I have to earn in the subsequent year to get my capital back to where it was. To the degree that an active manager gives you an option like payoff and can ameliorate your downside risk exposures while providing you with exposure to the upside, that's a more efficient way. Active management moves the efficient frontier to a much more attractive risk-return profile. No question. The pure volatility of passive indexes is a detriment to capital preservation.
Crigger: But is this across the board for commodities indices?
Armstead: No, well, some of the indexes have looked to provide variations on the original legacies, the GSCI, DJ-UBS framework where they moved you out on the forward curve in terms of where you roll, to find the least drag (because markets are in contango), or trying to take advantage of backwardation. But it's the same arsenal that's available to active managers on an ongoing basis. While I think those are definitely improvements in the traditional passive index strategies, I would probably suggest that there is still a fair amount of underlying downside beta associated even with those frameworks.
Crigger: What's your general outlook for commodities in 2010 and beyond?
Armstead: There are some general macro developments that are persistent. One is the increasing wealth of the total population, which means higher demand both for hard, raw process inputs—such as metals or petroleum—and that's likely to mean a higher food demand, or a higher-quality food demand. Those macro views, in general, I think will remain in place over time.
Crigger: Much farther than just 2010.
Armstead: Sure. And there will, of course, be variations in returns based on supply/demand outcomes and so forth, but I think the underlying real demand for commodities is in a secular uptrend. So I'm not going to say invest in corn vs. gold or cotton or whatever, but I think the general theme, at least from the demand side, is well-entrenched.
Crigger: Will the contango we see in pretty much every commodity these days continue?
Armstead: It shouldn't. We should move to less contango depending on the particular supply/demand dynamics. But for the active manager, I don't think it's that much of an issue. Active managers have the advantage in that scenario, certainly in regards to ameliorating some of the cost of ownership over time.