Canadians know that the past decade has been dominated by commodities. And Canadian indexes have outperformed – on the back of energy and mining players. But there’s more to commodity investing than publicly traded stocks, since, as stocks, they are subject to the same valuation rigour as other stocks. So they fall in a global financial crisis too,
That suggests a case for direct commodity investing, says Keith Black, Associate Director of Curriculum, Chartered Alternative Investment Analyst (CAIA) Association in Amherst, Mass. He was part of a panel presentation co-sponsored by the Canadian chapter of the Alternative Investment Management Association in Toronto this month.
“Commodities are far from a homogenous product,” he says, pointing to the dissimilarities between the S&P GSCI and the Dow Jones-UBS commodity index. The S&P/GSCI has an energy weighting of 67%. The Dow Jones-UBS index limits sectors to no more than one-third of the index weight. As a result, it has a lower volatility, but a similar return profile.
Investing is another matter. The most popular way is through exchange traded funds, which “are growing exponentially.” However, ETF investors are “finding that they are investing in just a single commodity market.” Commodity investments should be diversified across sectors, he argues. Different commodity sectors evince correlations of as low as 20%. For example, there have been recent rallies in corn, cotton and sugar that energy products have not participated in.
With commodity futures, it’s important, Black says, to understand the sources of return, There are three. The first is the spot price of the commodity. Then there’s the roll return. Futures contracts roll over every three months. Sometimes they are in “backwardation.” That means the current-month price is higher than the price for succeeding months. As the contract approaches expiry, it is “rolled” into the next available contract, creating a positive return.
Conversely, in times of tight demand, futures can be in “contango.” It costs less to buy now than it would in three months. For long-only investors, this means a loss in rolling over the contract.
A third element to the return is the collateral. Futures contracts are bought on margin, generally 10%. The rest of the investment earns the risk-free rate from Treasury Bills or real return bonds.
This explains, Black says, why a diversified futures strategy is more profitable than owning the physical commodity itself. The physical commodity returns less than the rate of inflation – even though commodities are widely heralded as inflation hedges – because there is no extra source of return. It’s simply the spot price.
Beyond that, spot prices tend to revert to the mean. A diversified portfolio of commodities minimizes contango, while delivering similar returns to stocks. Putting 10% into commodities in a 60/40 bond portfolio, say 5% on each side, would deliver similar returns (9.3% versus 7.9%) with reduced volatility (8.87% versus 8.19%), according to a study of returns over the past 45 years. Commodities have negative 42% correlation to stocks, and a negative 25% correlation to bonds. And a positive correlation to inflation of 0.452%
The diversification effect is achieved, in part, by exposure to the business cycle. Dividing the cycle into four parts, equities do well in the early expansion and late recession phases; commodities perform in the late expansion and early recession phases.
Contango, argues Roland Austrup, President and CEO at Integrated Managed Futures in Toronto, is why investors should look at managed futures. Managed futures can go long and short. Thus, in backwardation, they would buy long. In contango, they would short the futures contract.
Futures are not the return on the spot price of the commodity, although futures prices track spot prices, he notes. The futures price includes not just the spot commodity price, but also the cost of capital, storage, transportation and the risk premia from owning the commodity.
And, since spot prices mean revert over the longer-term, in line with supply and demand fundamentals, there’s little alpha – they “don’t generally provide a return above the rate of inflation,” Austrup says. Rebalancing futures, however, changes that: 3% above the rate of inflation.
Beyond that, the chief source of returns is the roll return, which turns commodity investing into an exercise in risk management.
“You’re managing risk and using allocation strategies … to constrain the volatility of the portfolio,” Austrup notes. “The second thing is getting on the right side of the market.” That is, whether it’s in backwardation or contango.
That requires an active, or alpha strategy. A beta strategy – pure passive investment – risks exogenous shocks, and in economic slowdowns commodity returns are negative. Managed futures, thanks to betting short, can provided consistent returns, he argues, by capturing the roll yield.
But commodity investing extends beyond holding the physical commodity or getting indirect access through futures markets. There is also direct holding of productive land – including timber and farmlands. But these are relatively illiquid – and long-term – investments, says Eva Greger, Managing Director of Renewable Resources, at GMO in Boston.
What investors are buying is the commodity, plus the productivity of the asset, less production costs. Thus, for timberlands, valuations are not closely linked to lumber prices, she says, even though spot prices do affect the current cash yield. With trees, there is an inventory, given a 25-year growing cycle. One can harvest now, if lumber prices are high, or postpone, if prices are low. So land prices for timber are somewhat attenuated against the spot market price.
In farmland, however, there is a closer connection to spot prices – you can’t leave the crops in the ground – which makes for higher land prices. Moreover, the cost of production is more variable.
The opportunities, on the institutional side, result from immature markets. Large tracts of farm or timberland require lots of capital, and so bids can be thin. “It’s a very expensive asset to acquire,” Greger says.