An Interview with Bob Greer

Bob Greer of PIMCO is one of the most important commodities portfolio managers in the world. As the executive vice president of PIMCO and manager of the RealReturn products (including the PIMCO Commodity RealReturn Strategy Fund), Bob helps oversee some $16 billion in commodities funds and has one of the more-established track records in the business. He spoke recently with the editors of HardAssetsInvestor.com about the commodities marketplace.

HardAssetsInvestor.com (HAI): Bob, thanks for taking some time with us today. Can you tell me a bit about your background?

Bob Greer (Greer): In the 1970s after having a background of undergraduate in Math and Economics at Stanford Business School, and some computer consulting, for reasons totally unrelated to my educational background I found myself involved full-time in the commodities futures markets. We had just barely seen the first stock index funds. It was at a time when the only players in the commodities markets were speculators or trade interests using them to manage risk.

I looked at the commodities markets a little differently and said, “Wow, the price of wheat is no more volatile than the price of IBM, but because of all the leverage people can use in commodities, they have this reputation for being very, very risky. What if you took the leverage out of a commodity position–[using] long-only, fully collateralized positions? What if you also didn’t try to guess what markets were going up or down, but allocated among a range of available commodities based on their relative importance to world trade? If you did that, you’d have a commodity index–something that would track the asset class. And then you could evaluate [commodities] in the context of an overall portfolio, not in isolation.

But this was in the 1970s. People thought the words “commodity” and “index” didn’t belong in the same sentence. But I did the research, wrote a paper, and ended up having it published in the Journal of Portfolio Management. If anyone goes back and checks history, that was in fact the first time an investable commodity index was ever defined.

HAI: Did the index have a life of its own after that?

Greer: I went on and did other things, given that there was no real interest in commodities index investment. In 1991, Goldman Sachs came out with their commodity index [now the S&P GSCI]. The head of the commodities department at Daiwa Securities knew that I was the first one to have created this idea, so he reached out to me and said, “How would you like to reincarnate your early work, update it, and bring it to market as a competitor.”

I jumped at the chance. I did that for about eight years, and then had the opportunity at PIMCO to bring my commodity experience to the broader world of RealReturn strategies, [which us TIPS as collateral].

HAI: PIMCO is a bit unique in that it’s being pretty active in managing the collateral.
Greer: By the time I joined PIMCO, they had already determined that the logical collateral for many investors would not be T-Bills, which is what’s used in the commodity indexes. If you had a choice, the more logical collateral would be TIPS, because they provide an additional inflation hedging component. They also provide more duration–if you have a positive slope to the yield curve, that’s an advantage. And if we could actively manage the collateral–given that PIMCO is an accomplished manager of fixed income–we could add value.

HAI: Turning to the market itself, how should investors be looking at commodities in the face of either a full on recession or just what’s going on in the credit market. Looking at $1,000 gold and $100 oil, investors get a little nervous.

Greer: My strong advice to investors is that they view commodities not as a tactical allocation, based on an expectation that commodities will go up or down, but rather that they view it as a strategic allocation with the acknowledgement that they’re not sure that commodities, or stocks, or bonds will go up or down.

Once you recognize your own inability to accurately predict with certainty the returns of any asset class in your portfolio, it forces you to the conclusion that you should diversify. And historically commodities have provided very strong diversification from stocks and bonds.

It’s easy for investors to look at what’s happened in commodities in the last six months and say “I want commodities because they’re going up in price” or look at what’s happened in the last week and say “oooh, I don’t want commodities because they’re going down in price.” The lesson to investors is “invest for the right reason” and the right reason is diversification, not because in the short term you think they’re going up or down. That’s not a good reason to invest in commodities.

HAI: That almost sounds like an indexer’s way of looking at things …

Greer: It’s an asset class approach; I wouldn’t call it an indexer’s approach because we actively manage against an index. But from a portfolio perspective, we believe commodities have a strategic role to play, and [investors] need to be thinking strategically in deciding to implement them. They might be concerned tactically about how much to implement, but the key decision is to think about a longer time frame. HAI: But “how much” can be tricky. Commodities still have a reputation as a speculative asset class.

Greer: I believe that a commodity investment in isolation will be as volatile as equities. If you think equities are volatile, then yes, commodities are volatile–in isolation. But I’ll emphasize just as I did 30 years ago that commodities should be viewed not in isolation, but based on their impact on your overall portfolio.

[Note: PIMCO sponsored an Ibbotson study on the issue of commodities in asset allocation back in 2006. Required reading.]

HAI: With that holistic approach in mind, there have been a lot of tweaks by indexers recently searching for outperformance. For instance, we’ve seen a lot of people looking at where on the curve to invest, and saying “we look X months out” for better returns.

Greer: First, It’s not sufficient to say that some strategy has worked historically. Second, it is suboptimal to lock into any single static optimized strategy. The opportunities for structural alpha represented by the strategies you’re talking about, and others … those opportunities come and go. It’s much more fluid and dynamic, and you have to constantly be aware of the range of existing strategies, and be aware of new strategies that come along, and know when they are more likely to work or less likely. There is no static approach that is best.

HAI: What about long/short strategies. We’ve some of these come to market …

Greer: So much of the work on commodities has been looking at long-only strategies, and that generally is the way the asset class is described. For someone who offers a long-short strategy, you might ask them, “If I pick up the newspaper six months from now and read that the price of wheat has gone up, can you assure me that that will be good for my portfolio?”

If someone truly has a long/short strategy then they might not know that they’ll always have a positive exposure to wheat, and in that case, I would say they’ve lost exposure to the asset class of commodities, and they’ve gained exposure to the asset class of gray matter. If the gray matter of the trader is good, they will get good returns.

You can compare it to a long/short hedge fund that works in equity space. Does that give you exposure to equities as an asset class? Or is the trader using equities as a way to exercise his grey matter.

HAI: Let’s turn to those speculators then. Do you think that because more money is flowing in that the historical role of commodities as an asset class is changing?

Greer: I think that the futures markets have become more volatile as a result of those flows. We’ve seen that in the markets recently as we’ve seen a flight from the dollar that drove up some futures prices. And then there was a perceived desire for liquidity, as people who might have problems with other parts of their portfolios liquidated some of their profits from their long positions in commodities.

There’s no doubt that those more active speculators, investors, hedge-funds–whatever you wish to call them–have added more volatility to the commodity markets. But in the long run–i.e. strategically–the price level of commodities will be much more determined by supply and demand for the physical product in the real world outside of the trading pits, because the futures price converges to the cash price more than the cash price converges to the futures price.

HAI: But what about if you look at something like gold, where investor demand is a component of that demand. Do we have a structural change in demand there?

Greer: Gold is the exception, because it trades more like a currency than a commodity. In addition, it’s one of the few commodities where investors hold the physical product. For commodity indexers–and I know this because PIMCO invests more than $16 billion tracking commodities indexes – we do not own, we do not horde, we do not store, we do not consume a single ounce of gold, a single bushel of corn, or a single barrel of oil. So we’re not adding to demand to the physical product. The only example of that is where someone might own the physical product, and gold–which is more like a currency–is that example.

HAI: But that $16 billion is definitely a source of demand for futures contracts. If the demand for the contracts dried up wouldn’t it have an impact?

Greer: It can in the short term. Most people talk about this in the sense of driving up the price of a commodity. It’s hard to drive up the price of something that’s in unlimited supply, or that has an outside of measure of its intrinsic value. Commodities futures are like that. What the index investor is buying is the futures contract, and there is no limitation on the number of contracts that can exist. If you want 300 crude oil contracts, if you pay the price, the floor of the NYMEX will create 300 more crude oil contracts. The price of that contract will eventually converge to whatever the refineries are willing to pay for crude oil, which is based on what you and I are willing to pay for gasoline. So you have the outside measure of the intrinsic value, which is different than say real estate, with constrained supply, or Dotcoms, which lost any measure of intrinsic value.

The movement in the futures markets does have information value that people in the cash markets use. I think that over the short term–we’ve seen this in the last week or two–financial flows can affect futures prices. But you do have the two governing mechanisms that inhibit the potential for a speculative bubble: you can have as many contracts as the market wants, and you have supply and demand in the real life markets like the gas pump and the grocery store that dampens any irrational exuberance.

HAI: What about platinum, lead and other thin markets. One of the concerns has been that the influx of speculative money could have an impact on the actual market where the products are used, or that the markets could be cornered.

Greer: We have regulations that are aimed at keeping financial players from cornering the market. They don’t always work. But the markets themselves can also punish those who try, most notably the silver play that we saw many years ago when the Hunt family tried to corner the silver market. But we do have strong regulation in the futures markets that are designed to inhibit the possibility of the market being cornered. We had a more recent example with Amaranth a few years ago, where the market showed that someone can actually be so big that the market will punish them, rather than reward them for their size.

HAI: Looking at the broad economy, in the short-term, we all worry about how our portfolio performs. How do you think rates, inflation and commodities are going to interact?

Greer: It’s going to be mixed for the next couple of years. We have a couple of things going on. For the next couple of years there is likely to be a continued weakness in the dollar. That means that for anything priced in dollars, including other currencies and commodities, it will be bullish in dollar terms. That however is offset by the outlook for a slower US economy, which will bleed over into a slower global economy, which will serve to reduce the growth of demand for commodities, and will also tend to reduce the rate of inflation, which also drives commodities. So it’s kind of a mixed bag of drivers over the next couple of years.

HAI: So the question becomes how those things balance out on any given day, month or year. One of the demand factors we hear about a lot is China, and it seems fairly inelastic. If they need copper to build houses, they need copper. Does that help keep demand up?

Greer: China specifically, and emerging economies generally, as they build out their infrastructure, will create ongoing demand for infrastructure-oriented commodities, namely base metals. But as they also improve their standard of living as the worker moves from the country to the city, they’ll be increasing their per-capita demand for consumption-oriented commodities. That worker will be buying his first car, his first house, his first washing machine. He’ll be improving his diet. All of that has a high commodities component. That’s why you’ll see the per-capita demand for commodities going up as the emerging commodities develop.

Let me leave you with a quote. This is from Harry Markowitz’ book on Portfolio Selection.

“Economic forces are not understood well enough for predictions to be beyond doubt or error … We are expecting too much if we require the security analyst to predict with certainty.”

Harry knows more about portfolios than I or anyone else I know. The reason I know this quote is because I use it as the theme when people ask me to talk about commodities. So often they say “Bob, tell me if the price of oil going up or down over the next six months.” So I have to say: A: It’s not all about oil, though oil is important.

B: it’s not about having certainty of where prices are going, and

C: it IS about understanding fundamental economics.

Comments

[rayhendon]

In my view, this interview should be mandatory reading for everyone who is looking to jump into the commodity pool. Mr. Greer's emphasis on strategic goals as the proper role for commodity investing as opposed to tactical objectives is spot on. It deserves a prominant place on the trading screen of all who are looking to commodities as a potential investment vehicle.