New Questions About Commodities as an Asset Class

by: Christopher Holt

A lot has been written over the past two years about the role of institutional investors in commodities markets. A report released by Watson Wyatt and the Financial Times last week showed that pension investment in commodities jumped from 0.4% of all pension assets to 2%, a whopping five fold increase. (Click here to see chart showing change to several other asset allocations.)

While more liquid futures markets makes direct ownership of commodities futures practical, many are apparently turning to professional money managers for their exposure. (Click here for list of the world’s top 20 commodity managers). Together the top 20 largest commodities managers run nearly $30 billion in commodities for pension plans (out of a total of about $75 billion of total commodities funds).

Commodities are often described as “alternative investments”. In fact, they comprise a healthy proportion of the curriculum of the Chartered Alternative Investment Analyst program. But as Ranjan Bhaduri, CAIA showed us in this post, commodities have been around since the beginning of civilization. Hardly a new alternative. In fact, you could argue that equities themselves are actually an alternative to wheat, oil and gold.

Advances in commodity investing have little to do with the underlying asset (the molecular make-up of oil hasn’t changed) and more to do with the securitization of commodities (as futures contracts) and the resulting opportunities for active management (“managed” futures). As Keith Black, CAIA (and 2010 Institutional Investor “Rising Star of Hedge Funds” – congrats Keith) argued in this post, long only positions in commodities have had ups and downs but were generally flat over the past decades. Black went on to say that the “secret” behind commodity investing was in non-directional return sources such as momentum and roll yield.

If you want long-only commodities exposure, mused Black, why not just buy the equity of commodity producers?

…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 (NYSE:AA) and Anglo American (OTCPK:AAUKY), while agricultural firms include Archer Daniels Midland (NYSE:ADM). In the energy sector, stocks such as Exxon-Mobil (NYSE:XOM), Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP) may be used as a crude oil proxy.

His answer: because you get a lot more exposure that you bargained for (think BP…):

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.

A Spring 2010 white paper by RS Investments, however, makes the counter-argument – that commodity prices have become so dependent on GDP growth that they have become highly correlated with equities. Says the paper:

Over the last 10 years, however, commodities have delivered more mixed results. Diversification benefits have been undermined by an increased correlation with equity markets, while returns have been partially offset by a shift in futures curves. Correlations with inflation have remained positive, but are almost identical to the protection provided by higher returning asset classes such as natural resource equities. As a result, many investors have begun to question the role that commodities futures play in a diversified strategy.

The paper contains the following chart to make the point:

In addition, RS Investments argues that spot price returns and roll yield returns have been sinking for decades, leaving only interest on collateral (for the futures contracts) as a source of returns by the 1990s.

That commodities markets are quickly evolving is not secret. The CAIA Level 2 textbook suggests that something is indeed afoot in commodities markets. In the introduction to the chapter on commodities, Richard Spurgin and Melissa Donohue write:

…the recent transformation of many commodity markets from purely commercial markets into markets with a significant investor presence leads to concerns that the historical track record may be of questionable value in projecting future returns…

But all is not lost, write Spurgin and Donohue. They also argue that, while the long term risk premium for holding commodities is “inconclusive”, certain anomalies make active commodity management (i.e. managed futures) profitable…

There is evidence that commodity prices exhibit short-term autocorrelation…Researchers have also rejected the hypothesis that commodity markets are weak-form efficient, as simple trading rules based on storage or momentum have been shown to deliver excess returns after adjusting for transactions costs.

So if buy-and-hold commodities strategies are a losing proposition, why would you buy and hold commodities equities? RS Investments says that at least you can hitch a ride on idiosyncratic (security-specific sources of return). Plus, like commodities themselves, commodities equities have provided a hedge against inflation over the past 10 years (see chart below from paper):

The paper goes on to show that the returns of various commodities equities indexes (e.g. the S&P North American Natural Resources Sector Index) have doubled the returns from commodities indexes (e.g. the S&P GSCI Total Return Index). That certainly beats broader equity indexes (although one would be excused for wondering if commodities equities are just a levered play on the underlying commodity prices.)

A solid return plus a hedge against longer-term inflation seems to give buy-and-hold commodities strategies a run for their money. Still both systematic and discretionary managed futures managers are quick to point out that the magic is still in the “management” not necessarily in the “futures” themselves.