By Drew Voros
When it comes to commodity indexes, the S&P GSCI is often considered the benchmark for the sector. Incorporating all commodity sectors and using a production weighting methodology, the index has hundreds of billions of investment dollars tracking it as well as other commodity indexes in the company’s index arsenal. HAI Managing Editor Drew Voros recently spoke with Jodie Gunzberg, director of S&P’s commodity indexes. Gunzberg talked about the company’s flagship commodity index and how it offers diversification and inflation protection; the importance of energy in an index; and active versus passive management when it comes to commodity investing.
HardAssetsInvestor: Anything out there in the commodities world that has surprised you so far in 2012?
Jodie Gunzberg: Well I don’t think too much about what is interesting about commodities until there’s a surprise, and it’s usually an upside surprise because there are supply shocks; so things like the EU and U.S. sanctions on Iran, the Sudan/South Sudan political pressures, what’s going on in Yemen. All of that pressures supply, which in turn actually supports the price.
An example for the other side — a demand shock — would be something like a mad cow scare that would send the prices of meat down. Demand shocks happen a lot less frequently than supply shocks. That’s one of the characteristics of commodities.
HAI: Your commodity index, the S&P GSCI, is well known to most commodity investors. What are some of the other indexes in the S&P family that commodity investors should be aware of?
Gunzberg: We actually have quite a number of commodity indexes at S&P and, of course, the S&P GSCI’s our flagship index. Beyond that, we have a family of modified-weight indexes. The S&P GSCI Light Energy Index is one of the more popular ones, along with the S&P GSCI Equal Weight Select. Those types of indexes are for investors who are looking for a commodity exposure with potentially less energy.
We also have modified-roll indexes. The S&P GSCI sits in the front-month contract and these modified-roll indexes fit in different spots. So we have a multiple-contract index — the S&P GSCI Multiple Contract — which we recently launched this year that sits in the first, second and third month forward. We’ve got forward indexes such as S&P GSCI 3-Month Forward that are one, two, three, four or five months forward. We’ve got an enhanced index — the S&P GSCI Enhanced Index — which has been around for quite a while, and was launched about the same time as the S&P GSCI, which modifies the roll of the eight hardest-to-store commodities. And why that’s important is that those hardest- to-store commodities are the commodities that have the biggest costs from rolling. They have the most severe curves when in contango.
We also have a newer launch that’s been really popular — the S&P GSCI Dynamic Roll Index — and that changes the roll on all 24 commodities.
HAI: And that’s designed to avoid contango?
Gunzberg: It’s designed to minimize contango and also to reduce trading costs. It doesn’t go to the single contract that has the least contango every month, but it might go to the one that’s the second-least contango or third or fourth, depending on the cost-benefit analysis.
HAI: Going back to S&P’s flagship commodity index, S&P GSCI, it’s up about 6 percent this year. What’s driving the index this year?
Gunzberg: Well, it’s mostly been the petroleum sector. Oil’s been up quite a bit. Brent crude oil, which is the second-heaviest constituent in the index, has been up more than 16 percent this year. That’s been a pretty big contributor. Even WTI crude is up at about 3 ½ percent up, but it’s more than 30 percent of the index, so that’s quite a big contributor as well.
HAI: Why does an index heavily weighted in energy make more sense than other commodity indexes?
Gunzberg: The index is a production-weighted index. If you believe something like the S&P 500 — which is a market-cap-weighted index — is a representative beta of the equity space, then the analogous situation in commodities is production weight. And the production weight yields a heavy energy because that’s the way that the world looks: There’s just more energy produced than there is corn or gold.
HAI: Can’t that work against an investor as well, if energy prices suddenly become depressed, then there’s an overweight toward that end as well, right?
Gunzberg: I think what’s attracted investors to the S&P GSCI despite the heavy energy weight is that historically it’s had strong diversification protection, it’s had a high-inflation protection and it’s also had the opportunity for equitylike risk and returns. When it was originally launched in 1991, those were the main drivers of the investments coming in. And since the bottom of the market in 2008, the assets have more than tripled. The diversification, inflation protection and the equitylike risk and return are driving those asset allocations.
And while, yes, there is a potential downside from the volatility of the energy weight, I think each investor has to measure the trade-offs of what are they trying to get. So as you reduce energy, you might be reducing long-term volatility, but you might also be reducing your inflation-protection properties. It takes energy to make other commodities. You need oil in your tractor to grow the wheat.
Large pensions looking for commodity allocation prefer the S&P GSCI because energy is the most liquid sector. If you’re making a 5 or a 10 percent allocation to commodities from a multihundred-billion-dollar plan, you might really need the liquidity that the S&P GSCI’s got to offer.
HAI: For the most part, the experts say commodities don’t have much of a correlation between each other. Yet on a big day, we’ll see all the commodities moving in one direction. Is there a correlation or is it just a case-by-case trading-day kind of example?
Gunzberg: Correlations over the long term are relatively low. A pipeline burst doesn’t affect corn, and a drought doesn’t affect gold. The reasons that drive these things are different. I did not look at a study of daily returns, but I did look at annual returns. And going back since 1984, there were only five years where each of the sectors moved in the same direction, but in four of those years, that direction was up, not down.
HAI: Natural gas, which is obviously a component of GSCI, has seen its price go down all year, which means you’re fighting roll costs. Is there anything you have to do in regard to that, or do you just let it play out?
Gunzberg: We do just let it play out. Right now, natural gas is only 1.4 percent of the index, so it’s relatively small. It’s almost like it takes care of itself. If it goes down enough, it will reduce its weight in the next rebalance. And because of the small weight, it hasn’t had a detrimental impact to the index. How natural gas does for the rest of the year will drive the production weight for next year. The production weight is how the weights get set at the beginning of the year.
HAI: Regarding your first-generation indexes, would you say these are better now to measure the market rather than to invest with?
Gunzberg: It depends, again, on the investor. But I think it is definitively a more representative benchmark for the way that the landscape looks. But is it a better benchmark for every active manager? I don’t know; that’s up to the active manager to decide. And as far as the investments, I think that the development of the modified-weight indexes, the modified-roll indexes were without a doubt in response to investor demand. As investors have different tastes for different types of volatility or where they want to sit in the curve, we’ve developed those indexes so that they can use a modified version to fit their portfolio solution.
HAI: What are some of the things an investor should look for in an index?
Gunzberg: The most important thing to look for would be diversification. If it’s an investor just looking to get in who doesn’t have a strong view on a sector or a single commodity, and if they just want exposure, I would say a broad-based index is something they should be looking for. As far as where to sit in the curve, it makes a difference, but it makes a difference at different times. It’s actually the storage situation that drives a relationship between the price of a contract that’s expiring near and the price of a contract that’s expiring far. When there’s a shortage, that’s when you get backwardation, which is when the near contract is more expensive than the next contract. That’s because there’s a premium on having the commodity right now.
In a situation of abundance, there’s a cost for storage. The contract expiring further will reflect those storage costs and they will force the curve into contango when the costs are positive or high. So something like natural gas, where there has been an abundance of production, the price goes down and you have contango. Dropping prices often go with contango because that means that there is more supply than demand, so the price will drop and the price of storage goes up. The problem is that you don’t know when there will be a shortage situation or when there will be an abundance. So you could sit in the front month and over the long term, a premium for sitting in that front month can happen. But if an investor’s not comfortable there, then of course something like an enhanced-dynamic roll or multiple contract could be a choice as well.
HAI: Are there any thoughts or any areas you’d like to touch on before we close?
Gunzberg: There are a lot of questions about active versus passive management. And one of the things about commodities is that active management can be accretive because it’s an area where there is a lot of alpha to be gained.
When you go shopping for a commodity investment, active management seems like an attractive opportunity because there’s a lot of alpha in the space. But when you actually look, there are not a lot of choices. One is because commodities can be so volatile, like for example in 2008, when the S&P GSCI lost almost two-thirds of its value, no money manager could withstand that volatility. They would go out of business. So what you get is a really small, concentrated choice of managers. And then even further, a lot of those managers use things like over-the-counter swaps, they do private deals. A lot of them think they can trade futures because they were trading equities and they try and they don’t realize the delivery rules and they get squeezed. There are a lot of risks that come with the active management as well.
I’ve seen a lot of debate going on in the press lately about active management versus passive management. And again, if an investor feels they can take the fees and withstand the risks, than maybe active would be a good place for them. But I think that for the majority of investors just getting into commodities, those risks are pretty high.