|The Bahamas Investor Magazine
January 1, 2009
January 1, 2009
David W Burkart
Commodities can strengthen portfolios by offering a risk premium and a different risk profile and source of return than traditional investments. Consequently, commodities offer low correlations with such traditional investment instruments as equity and debt, and access is widely available to both retail and institutional investors. A five per cent allocation offers an improved efficient frontier on an expected basis for both the aggressive and conservative investor.
Why include commodities?
Commodities are assets of physical substance—think of oil, gold, or cattle—which makes them intrinsically different from stocks and bonds and, therefore, a different source of returns. Commodities can provide a forward-looking risk premium, although they may require a strategic holding period to realize this. Furthermore, commodities reduce overall risk by providing portfolio diversification. Commodities have low correlations with traditional asset classes and with the overall business cycle. Finally, historical data indicates that the long-term return and volatility on unlevered commodities beta has been only modestly higher than that of large-cap US equities.
Unlike other alternatives, commodities are liquid, offer transparent implementation, and can now be easily accessed through exchange-traded futures contracts or exchange-traded products.
Commodities also provide a hedge against unexpected inflation and event risk. For example, a strike at a mine is usually bad for the firm’s equity but good for the commodity price. In addition, commodities can hedge pricing pressures caused by global growth. Not just China and India but also Indonesia, South Africa, Mexico, Russia and other countries have moved up the development chain and are consuming more commodities more intensely on a per capita basis.
Before committing to commodities as a regular ingredient of their portfolios, investors need to consider several factors. First, commodities are volatile. Therefore, if investors are going to use commodities, they must be risk tolerant and be willing to commit to the asset class strategically. When seeking the return expectation as discussed earlier, investors must be prepared for double-digit risk levels. In addition, because of the volatility and risk levels, many investors seem to be comfortable with a modest allocation—five to 10 per cent at the most. Finally, investors must choose an index and product to execute on the concept.
Positive expected returns
Returns on commodity futures contracts can be expressed as the sum of the returns from three sources: spot price return, roll return and income return. Spot prices generally increase over time; for example gasoline generally costs more today than last year. For roll return, as the futures “roll over” from the current contract to the next one, gains and losses are often generated. Income return arises from cash collateral (recall that there is no leverage so every dollar of futures is backed by a dollar of cash). In total, Barclays Global Investors postulates that these three aspects lead to a six to eight per cent expected annualized return over a ten-year time horizon.
Regarding the price returns, one can see that by analysing the S&P GSCI (formerly Goldman Sachs Commodity Index) that the mean rolling twelve-month spot-price return from 1970 to June 2008 was approximately two per cent. But the last ten years is over 5.5 per cent due to strong growth worldwide. Therefore, an overall two to four per cent expectation is reasonable per your view of global gross domestic product (GDP) growth.
As for the roll return, it can be seen as being analogous to the reinvestment return of a dividend on an equity investment or to the interest payment on a bond. The roll return is a means of indicating the compounding value of the commodity investment over time. The annualized roll return on the S&P GSCI since inception to June 2008 was 0.5 per cent, with the energy sector at 2.1 per cent. On a forward basis, a zero to 1.25 per cent range is reasonable depending on the energy allocation (from low to high) in the index.
Why the roll opportunity with energy? Basically, whoever produces an energy commodity decides when to extract it: Saudi Arabia, Kuwait, Iran and Venezuela choose to pump or not to pump. The timing of production depends on the benefit to the producers. They might choose to pump today because spot prices attract production, but during “contango,” in which the price of the commodity for distant delivery is higher than the current price, producers might delay production to earn that higher revenue. In the meantime, the commodity is stored, in the case of oil, in the ground. The related carrying cost is minimal, especially when compared to the carrying costs of a commodity that is stored year-around, such as wheat or corn. This tendency to maximize the present value of oil production with minimized storage costs creates this roll opportunity.
For income return, the current US Treasury Bill or money market yield is a reasonable, though simple, guideline for this component. Adding the three portions together constructs the six to eight per cent expected total return.
Annualized historical volatility ranges from 13 per cent to almost 20 per cent for the asset class—equity-like risk levels. This volatility shows no sign of abating so these levels can be used for an expected risk level.
Building on information commonly available and using five-year, 10-year, and longer rolling periods, one can see that correlations range from positive 30 per cent to negative 30 per cent. However, as the time period lengthens, the overall correlations between commodities and other asset classes (equities, emerging markets, bonds, REITs) tend to move toward zero. Note that certain markets do have higher correlations, such as Australia or Canada, but at 50 per cent do not replace commodities futures. Instead of acting as a substitute, commodities act as a complement to equities, even those that are commodity related.
Bringing together positive expected returns, equity-volatility and low correlations, generates a high commodities allocation for many portfolios. An unconstrained optimizer might recommend close to a 35 per cent allocation for an aggressive portfolio. However, typically investors use a much smaller percentage centering on five per cent, +/- three per cent.
There are many choices available today versus a few years ago. A number of exchange-traded products and mutual funds are available. Index futures contracts, swaps, structured notes have different credit issues and levels of customization. Investors can, of course, manage their own trading of individual commodities, or they can outsource the management to a professional, such as a CPO (commodity pool operator), a CTA (commodity trading advisor) or hedge fund. While alpha can be exciting, the beta options offer the return-risk-correlation combination at a lower cost with great transparency.
The number of futures-based commodity indices is good-sized. Some of the more prominent ones are the S&P GSCI, Dow Jones-AIG Commodity Indexes, Rogers International Commodity Index, Reuters/Jefferies-CRB Index (see above graph), and Deutsche Bank’s DB Commodity Index. Commodity indices differ in many ways: market coverage, weighting method, rebalancing frequency, length of live history, data availability and investment options. Nevertheless, the indices have two valuable similarities. They are highly correlated with one another (within a general range of 70-90 per cent), and they have a low correlation with traditional asset classes (historically zero to 10 per cent overall). Thus the choice is less about the “right” index but more about the asset class overall and the associated transaction costs to gain the exposure.
With commodity prices so high and questions on global growth, is now the right time to invest in commodities? While positive returns are never guaranteed, adding commodities is just as much about risk reduction (“surprise protection”) as it is seeking return. Even with the slowing economies in the US and Europe, this is still a tight inventory environment as emerging markets are operating at a higher level of activity than a few years ago. China and India may be slowing, but are still reaching higher levels of consumption. On the supply side, the quality of oil is lower, energy supplies are at risk from political disruption (Nigeria, Venezuela and Russia to pick a few geographies) and new uses are being found for inventories already in tight supply (eg using sugar, corn and soy as fuel rather than food).
Commodities offer a positive expected return premium, strong diversification effects, and unique risk hedging. Commodities cover a part of the risk spectrum that other asset classes do not and therefore contribute a sustainable risk-reduction benefit. Like other asset classes, commodities offer a range of benchmark choices and investment vehicles across the alpha-beta spectrum. As part of an offshore finance centre and operating in an economy dependent on commodities imports, an investor looking at The Bahamas has a number of compelling reasons to consider this asset class for themselves and their clients.
David W Burkart, CFA
David W Burkart leads the marketing, portfolio management and investment research for Barclays Global Investor’s (BGI) institutional and retail commodities-related products. Before joining BGI, Burkart worked at Gap Inc in international treasury and corporate finance. Previously, he was employed at Bank of America in foreign exchange and syndicated lending. He has a BA in economics from University of California, Santa Barbara and an MA from the University of Virginia in foreign affairs, focusing on the emerging economies of East-Central Europe. He also has an MBA in finance from Wharton School of Business. Burkart is a chartered financial analyst charter holder and holds the FINRA Series 3, 7 and 63 licences.