TOPICS OF INTEREST

Institutional Investing in Long Commodities Strategies

By Eyal Bilgrai, CFA, CAIA Senior Research Associate

MARCH 2013 Executive Summary ▪ Historically low correlation between commodities and financial assets, such as stocks and bonds, means that commodities should help institutional portfolios generate better risk-adjusted returns by contributing to the diversification in the investment portfolio. ▪ Commodities tend to perform better than most financial assets during periods of inflation because commodity prices reflect a trend in rising prices of essential goods. ▪ The major commodities indices have inherent drawbacks, which may provide opportunities for active management to add value. Introduction Commodities are defined as raw materials that can be bought or sold; e.g., oil, copper, coffee, corn and gold. Most institutional investors consider commodity futures as a separate asset class due to differentiated exposures to economic drivers and unique return characteristics. The main reasons for investing in commodities includes diversification benefits, overall portfolio risk reduction, and inflation protection. This paper will discuss the attributes of long-only commodities investing and will also address the benefits of active management in the asset class.1 Commodity markets While stocks and bonds provide legal claims on cash flows, commodities provide a legal claim on raw material goods. Valued as a consumable or a transformable asset,2 commodities do not conform to traditional asset pricing models (such as the capital asset pricing model)3 and they cannot be priced by traditional accounting metrics (such as net present value). Commodity prices depend on global supply and demand dynamics, not what market participants perceive to be the acceptable risk premium. The major commodities sectors are: agricultural, energy, industrial metal, livestock, and precious metals. Gaining exposure to commodities Commodities exposure can be achieved through five ways: purchasing the underlying commodity, commodity future contracts, commodity swap and forward contracts, commodity-linked notes, or equity in natural resources companies: ▪ Commodity futures contracts: This is the most common method of gaining exposure to commodities. Futures contract trading occurs in a central marketplace and has transparent pricing, clearinghouse safety, uniform contract terms, and daily liquidity. Only a small percentage of futures contracts results in delivery of the underlying commodity. ▪ Outright purchase of the underlying commodity: The physical purchase and holding of a commodity entails practical difficulties including transportation, storage, and insurance. This is not prudent for most plan sponsors. With the rise of bullion exchange traded portfolios (ETFs), investors can purchase a share of actual physical commodities, although this method is limited to a small sub-set of commodities, mainly precious metals.4 ▪ Natural resources companies: Owning stock in natural resources companies is not considered a pure commodities play because the pricing tends to follow the general movement of the stock market (equity risk factor) and exposes investors to company specific risk.5 ▪ Commodity swap: Total rate of return swap that delivers the performance on the underlying price basket.6 An example would be agreeing to exchange cash flows linked to prices of oil for a fixed cash flow. There is generally no central exchange for swap transactions and so they tend to be less liquid than commodity futures. Commodity swaps also expose the investor to counterparty risk. ▪ Commodity-linked notes: A commodity-linked note is a structured product that pays a return linked to the performance of a commodity or basket of commodities. On its maturity date, the note pays the initial principal amount plus the return based on the price change of the underlying commodity. These notes expose investors to credit risk of the notes issuers. The difference between commodity swaps and commodity-linked notes is that commodities-linked notes are fully funded, while swaps are mainly unfunded. Commodities Futures A commodity futures contract is a single commitment to buy or sell a commodity at a future date. If the seller or buyer of the futures contract wishes to avoid delivering or accepting delivery of a physical asset, the position must be closed out by selling or buying an offsetting position prior to the contract expiration. An investor who wants to maintain long exposure to commodities over time through buying futures contracts must continuously open and close positions - a process referred to as “rolling the position.” To trade futures contracts, only a small initial margin must be posted as collateral against fulfilling the commodity futures contract commitment. The initial margin for holding a commodity future is typically 2%-10% of the value of the contract. For each commodity, there are several futures contracts with different maturities. The nearest dated contract is often the most liquid. Pricing of Commodity Futures Commodity futures contracts exhibit a term structure similar to interest rates. The commodity futures curve can be downward or upward sloping, and the slope of the curve serves as a market signal to hedgers and speculators. The pricing of a commodity futures contract depends on the commodity spot price (i.e., the price of the physical commodity actively traded in the open market), as well as storage and insurance costs, the risk free rate, and the commercial risk allocation (i.e., who bears the risk of

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commodity price change) between commodity consumers and producers, or hedgers and speculators. Storage and insurance costs tend to inflate the value of a futures contract, while commercial risk allocation can serve to reduce the value of a futures contract, especially when physical availability of a commodity is perceived to be low. Interestingly, though we are using commodities futures as investment instruments, the commodities futures market only exists because of the inherent uncertainty in commodity production and demand. Without this uncertainty, there would be no economic reason to enter such a risk-transfer agreement. Generally, when a commodity futures curve is upward sloping, referred to as contango, the commodity is physically readily available. As a result, the higher price of the futures contract relative to the commodity’s spot price is being derived from the insurance and financing costs associated with holding physical commodities. For example, when oil inventories are high and there is little geopolitical instability, commodity consumers are less concerned about a spike in oil prices and are not rushing to buy oil. The price of the oil futures contract will be derived from the oil spot price plus the storage and financing costs. This was the case in 2009 when oil storage in the United States nearly reached its maximum capacity resulting in moving the curve to its widest contango on record.

Contango / Backwardation 120

100

Price 80

60 1 2 3 4 5 6 7 8 9 10 11 Contract Maturity/Expiration (Months) Curve in Backwardation Curve in Contango Conversely, when the commodity futures curve is downward sloping, referred to as backwardation, commodity consumers are willing to pay a premium for accessing the physical commodity. The market is signaling to producers that they can realize a higher price for their commodity today versus in the future, while a consumer who can delay consumption can obtain the commodity for a cheaper price in the future. For example, when oil inventory levels are low and geopolitical tensions are high, commodity consumers become concerned about near term oil supply shortages, and are willing to pay a premium for immediate delivery. In this situation, we would expect the future curve to be in backwardation. This situation existed in early 2004, when the Iraq War caused an oil shortage concern.

There is a clear negative correlation between oil inventories and oil prices 200 20

10 100 0 0 -10 change, % performance,% 12 month rolling 12 rolling month -100 -20 12 month rolling invemtory rolling month 12

S&P GSCI Energy U.S. Ending Stocks of Crude Oil and Petroleum Products Source: U.S. Energy Information Administration, Morningstar Indices, Wurts and Associates calculations.

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Speculators play a pivotal role in the commodities market by taking the counterpart position to hedgers in a futures contract. This allows real businesses to hedge their commodity exposure.7 We do not agree with the notion that speculators can significantly distort the price of commodities for an extended period of time. Instead, we believe the long-term price trend is determined by the marginal cost of production, though in the shorter-term, cyclical supply and demand factors will drive price variability around that trend: New sources of supply, geopolitics, weather, natural disasters, income growth, demographics (especially in emerging markets), and productivity all affect the long-term pricing of commodities. Return sources for commodity futures Commodity futures returns are often decomposed into three elements; spot price change, collateral return, and roll return. Spot price change is simply the change in the market price of the commodity, which is driven by supply and demand variables. Collateral return refers to the income earned on the cash collateral underlying the notional value of futures contacts, which typically earn the short-term Treasury rate. Roll return depends on the shape of the futures term structure explained above. The gain or loss from rolling the position is zero if the price of the contract is the same as the previous one. If the term structure is in backwardation, the roll return is positive because the new futures contract can be bought at a lower price than the previous contract was sold. Conversely, when the term structure is in contango, the roll return is negative. The chart below breaks down the return component between the total return and the roll return. We show the S&P GSCI Reduced Energy index because of the overwhelming energy allocation that makes some investors leery of using it as a benchmark. The Reduced Energy index has a data series that goes back to 1970, while the DJ-UBS index return series starts in 1994.

S&P GSCI Reduced Energy Returns vs. Roll Yield 36 Month Rolling Annualized Return 60% 40% 20% 0% -20%

GSCI Reduced Energy Roll Yield GSCI Reduced Energy

Source: Morningstar Indices, Wurts and Associates calculations. The long-run average returns across commodities are strongly influenced by roll returns. Typically, commodities with positive roll returns earned positive excess returns, whereas commodities with negative roll earned negative excess returns. For example, in 2009, the spot price of crude oil (WTI) appreciated by 78%, but the passive index crude oil allocation gained only 7% after incurring negative roll yield. Some studies suggest that overweighting commodities with a backwardation term structure, and underweighting those in a contango term structure has added value over time.

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Breakdown of the historical return components of the S&P GSCI Commodity Index, % (01/1983 - 08/2012)

9.0 0.5 4.6 4.6 4.6 4.5 4.5 4.5 4.0 4.5 4.2 3.9 3.2 4.2 4.1 4.5 1.5 -1.0 -1.6 -1.9 -0.6 -2.7 -5.6 -4.1 -6.0 GSCI GSCI Reduced Agricultural Energy Industrial Metal Livestock Precious Metal Energy Spot Return, % Collateral Return , % Roll Yield, %

Source: Morningstar Indices, Wurts and Associates calculations. Commodity indexes The common commodity benchmarks reflect all three components of a commodity futures investment (spot price change, collateral return, and roll return) and are constructed using trading volume and annual production indicators to determine the weight of each commodity.8 The benchmarks have different correlations and risk return profiles that need to be considered. Designed as an economic indicator, the GSCI is a production-weighted index that is built to reflect the relative significance of each commodity to the world economy, while preserving the tradability of the index by ensuring adequate liquidity for the futures contracts. Constructed with 24 commodity futures, the GSCI assigns a weight to each commodity in proportion to its flows through the global economy, using a five year average contribution to world production. Energy is the largest sector of index, with a weight of approximately 75%, which detracts from the GSCI diversification benefits. Constructed with 22 commodities, the DJ- UBS is designed to provide both liquidity and commodity diversification. The DJ-UBS relies primarily on liquidity data to determine the weighting of each commodity in the index, and assigns a weight to each commodity by the relative amount of trading activity associated with that particular commodity. The index also relies, to a lesser extent, on dollar-adjusted production data to determine index weights. Importantly, the DJ-UBS assigns diversification rules which prevent any commodity sector to represent more than a third of the overall index. Thus, unlike the GSCI, energy is limited to no more than 33% of the index at the time of its annual rebalancing. Due to its broader capital and risk diversification, the DJ- UBS is the index of choice for most institutions.9 Why institutional investors should invest in the commodity asset class Within a portfolio context, investing in commodities provides investors with exposure to a new source of risk premium generated by taking short-term price risk from commodity producers. The long-term return profile of commodities is similar to the equity market.10 Unlike equities or bonds, long-term economic and interest rate expectations have less of an impact on commodity returns. Instead, they are influenced by current supply and demand conditions. This leads commodities to behave differently from bonds and equities at different stages of the business cycle. In certain cases, unexpected volatility in commodities has been known to disrupt the progression of the business cycle. As a result, adding commodities to a traditional long-only portfolio improves its diversification and efficiency.11

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Commodities also provide event risk protection as they have positive exposure to unexpected supply disruptions due to geo-political issues, natural disasters, etc.

Adding Commodities reduced risk Adding Commodities improved efficiency 120 Month Rolling Annualized StdDev, % 120 Month Rolling Information Ratio (return/risk)

14 2.5

12 2 10 8 1.5 6 1 4

Information Ratio 0.5

Annualized StdDev, StdDev, Annualized % 2 0 0

50% Stocks/40% Bonds/10% Commodities 50% Stocks/40% Bonds/10% Commodities 60% Stocks/40% Bonds 60% Stocks/40% Bonds

The correlation between bonds and commodities Correlation between stocks and commodites has always been low/negative. The chart below inceases at the beginning/end of business cycles plots the 10 year bonds/commodities correlation 0.5 10 0.4 8 0.2 0.3 6 0.1 0.2 4 0 0.1 2 -0.1 0 0 -0.2 -0.1 -2 -0.3 -0.2 -4 -0.3 -6

Intermediate Term Goverment Bonds

Long Term Corporate Bonds Stocks/Commodities 10 Yr correlation Long Term Goverment Bonds GDP 10 year annualized growth

Source: Morningstar Indices, U.S. Bureau of Economic Analysis (BEA), Wurts and Associates calculations; commodities allocation is modeled with S&P GSCI Total Return Index. In contrast to equities and bonds, commodities may provide investors with a natural hedge against short-term and/or unexpected inflation. Commodity returns have been positively correlated to both inflation and unexpected inflation, while equity and bond portfolios are negatively affected by unexpected inflation.12 Therefore, we believe that including commodities in a typical institutional portfolio may improve the portfolio efficiency, reduce the downside of the portfolio, and provide a hedge against inflation. We also distinguish between commodities and other real assets as inflation hedges: we generally think of commodities as having the highest beta to inflation versus Treasury Inflation-Protected Securities.

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Correlation to inflation, quarterly, Apr-97 to Sep-12

TIPS 0.21

Interm Gov Bonds -0.42

Long Corporate Bonds -0.40

Long Gov Bonds -0.40

GSCI 0.56

Stocks 0.13

-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 Unexpected inflation Inflation

Source: Morningstar Indices, Wurts and Associates calculations

We also highlight the diversification that exists within the commodity asset class. Each sector is diversified and tends to hedge a unique type of inflation (energy: energy supply shocks; industrial metals: wage growth in emerging markets; precious metals: monetary-led inflation and stagflation; agriculture and livestock: food price inflation which also drives monetary policy in emerging markets). Also, each commodity sector tends to perform differently under various growth environments: industrial metals do best when growth is rising, while precious metals may outperform when growth is struggling. Energy benefits from strong growth, but it can also affect the path of that growth. Agriculture and livestock tends to be more growth agnostic and therefore defensive. Lastly, commodities tend to have a negative correlation with the dollar. When the dollar strengthens relative to other major currencies, the prices of commodities typically decline. When the value of the dollar weakens relative to other major currencies, the prices of commodities usually increase since the majority of all commodities are priced in U.S. dollars. A decline in the dollar means that more dollars are needed to buy commodities; therefore, adding commodities to the portfolio in effect diversifies currency exposure, especially the large dollar-bias of most institutional portfolios in the United States.

60 Month Rolling Correlation between commodities and Nominal Major Currencies 12/1974 - 12/2012 0.5

0

-0.5

-1

GSCI GSCI Reduced Energy

Source: Morningstar Indices, Wurts and Associates calculations

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Active versus passive Currently, the majority of institutional investment in commodities is index-based. Conceptually, index buyers benefit from “normal” market conditions when they are compensated for taking the spot price risk away from producers. However, there are three main drawbacks with passive long-only commodity indexing (most notably the GSCI and DJ-UBS): inability to cope with upward sloping futures curves (contango) that lead to negative roll returns in times of inventory surplus; commodities sector weights without sound investment foundations; and a predetermined trading schedule that is exploited by commodity traders. As a result of these drawbacks, newer active long-only strategies are gaining popularity. While both the S&P GSCI and DJ-UBSCI have become popular with commodity investors, they were not originally designed to serve as the basis for investable products. The indexes invest only in the respective futures contracts that are closest to expiration. As a result, turnover is elevated by the need to frequently roll futures positions forward to the next contract, which in turn leads to significant trading costs. Active long-only commodity managers seek to generate excess returns over the benchmark by . managing roll yield; . allocating among sectors based on fundamental investment rationale; . generating additional excess returns with relative value spread trades. Active roll yield management attempts to minimize the negative performance associated with rolling futures contracts in an upward-sloping futures curve environment. The main risk of deviating from the index by extending the contract term is underperformance when the futures curve shifts from contango to backwardation (from upward sloping to downward sloping) due to short term spikes in demand, supply disruption, or shifting market expectations of future supply/demand. It is also worth noting that given the high volatility of individual commodities and the low correlations between them, it makes an attractive combination for active managers.

Historical Correlation between commodities sectors (01/1983 - 09/2012, monthly)

Agricultural Livestock Precious Metal Industrial Metal Energy Agricultural 1 0.03 0.23 0.25 0.12 Livestock 0.03 1 -0.02 0.02 0.07 Precious Metal 0.23 -0.02 1 0.26 0.19 Industrial Metal 0.25 0.02 0.26 1 0.18 Energy 0.12 0.07 0.19 0.18 1

Source: Morningstar Indices, Wurts and Associates calculations

Additionally, the predominance of systematic momentum traders in the asset class offers opportunities for managers who are more value-driven. Lastly, the presence of hedgers indeed offers active managers opportunities to provide liquidity to them when price risks appear greatest.

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Conclusion This paper provides a brief summary of institutional commodities investing. Wurts & Associates advocates a strategic allocation to commodities within portfolios as a means to improve the portfolio’s diversification and economic risk factor exposure. Wurts & Associates also believes that the major commodities indices have inherent drawbacks (including: inability to cope with negative roll returns; commodities sector allocation investment foundations; and a predetermined trading schedule), which may provide opportunities for active management to add value.

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Appendix: Commodities Index Construction Methodology DJ-UBSCI S&P GSCI Inception date (backfilled) 1998 (1991) 1991 (1970)

Constituents 20 24

Selection, weighting criteria Liquidity, world production13 World production14

Futures selection Nearby futures contracts Nearby futures contracts

Contract country of origin US, UK US, UK

Diversification rules Yes15 None16

Roll frequency Varies Monthly

Roll window 5th-9th US business day 5th-9th US business day

Rebalancing Yearly17 Yearly18

Price rebalancing Yes No

Sector Allocation

Energy 30% 71%

Agriculture 38% 19%

Precious Metals 13% 3%

Industrial Metals 19% 7%

Appendix: Commodities sensitivity to expected and unexpected inflation Regression analysis Unexpected Regression analysis (Month, Unexpected (monthly, Feb-1970/ Inflation Inflation Inflation Jan-83/Aug-2012) Inflation Aug-2012)

Commodities Coefficient 2.49 2.56 Coefficient 8.64 4.75 S&P GSCI Energy (GSCI) T-Statistics 3.29 3.13 T-Statistics 4.73 2.97

Coefficient -1.12 -1.3 S&P GSCI Coefficient -0.14 -0.08 Stocks Agricultural T-Statistics -1.88 -2.03 T-Statistics -0.12 -0.08 Intermediate Coefficient -0.43 -1.17 Coefficient 1.42 -0.02 Term S&P GSCI Livestock Government T-Statistics -2.01 -5.23 T-Statistics 1.67 -0.03 Bonds

Long Term Coefficient -1.6 -1.96 S&P GSCI Precious Coefficient 1.23 2.72 Corporate Metal Bonds T-Statistics -4.38 -5.02 T-Statistics 1.23 3.21 Long Term Coefficient -1.68 -2.26 S&P GSCI Industrial Coefficients 3.92 2.52 Government Metal Bonds T-Statistics -4.12 -5.2 T-Statistics 2.81 2.09

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Notes

1We view absolute return commodities strategies (hedge-funds/CTAs) as a part of an absolute return allocation, which depends on manager specific skill and/or idiosyncratic market inefficiencies rather than a strategic allocation.

2A transformable asset is an asset that can be changed to a consumable form, for example, wheat into bread.

3The Capital Asset Pricing Model describes the relationship between risk and expected return for securities. The model states that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. The model was developed by Jack Treynor (1961, 1962), William Sharpe (1964), John Lintner (1965) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. Read more: http://en.wikipedia.org/wiki/Capital_asset_pricing_model.

4For example, SPDR Gold Shares (GLD), iShares COMEX Gold Trust (IAU), iShares Silver Trust (SLV), ETFS Physical Palladium Shares (PALL)

5Energy-related equities and natural resources products are often pitched as a mean of obtaining inflation protection. It is also argued that the performance of these products is far better than that of future-based commodities because of the negative roll yield associated with commodities. Our analysis indicates that energy related equities do improve the inflation/unexpected inflation sensitivity of the portfolio. But, the inflation co-efficient (beta) of these products is low relative to commodity future contracts. Also, given the high equity beta of commodity- linked equities, the diversification benefits relative to a futures based strategy are lower.

6Read more: http://en.wikipedia.org/wiki/Commodity_swap.

7Speculators are defined as those without a direct business interest in buying or selling commodities. Read more: Jacks (2005), in "Populists versus Theorists: Futures Markets and the Volatility of Prices" and Sanders & Irwin (2010) "Bubbles, Froth, and Facts: The Impact of Index Funds on Commodity Futures Prices."

8Market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. In the futures markets, there is no assurance that a liquid market may exist for offsetting a commodity contract at all times. The most useful indicators of liquidity for these contracts are the trading volume and open interest. Read more: http://en.wikipedia.org/wiki/Market_liquidity

9See Appendix for details regarding index construction methodology.

10The S&P GSCI has returned 9.7% per year since 1970, basically in line with the 10.1% return of the S&P 500 Index for the period 1/70 – 1/12. There is significant volatility on a per year basis and commodities may not outperform every year or over the short- or long-term.

11Measured over long horizons, the correlation between stocks and commodities is close to zero. However, it varies widely over time. The correlation is higher during periods of economic weakness. The same pattern is observed in the average intra-commodity correlation.

12 We calculate expected inflation as the difference between CPI (US BLS CPI ALL Urban SA 1982-1984) and 30 days Treasury Bills (IA SBBI US 30 Days T-Bill).

13Weighted by both liquidity (2/3) and dollar-adjusted historical production (1/3).

14Production weighted by 5-year historical production amounts.

15Diversification rules limit exposure to any one commodity (15%) or sector (33%); 2% minimum allocation to any commodity.

16No predefined commodity or sector limits. No minimum allocation to any commodity.

17Annual price-percentage rebalancing (no intra-year re-weighting).

18Annual rebalancing (no intra-year re-weighting).

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