Commodities: Capturing risk premium
The risk of inflation hangs ominously over the heads of investors, so an active approach to commodity investing could be the way to maximise risk-adjusted returns, says Brent Bell
Monetary easing, near-zero interest rates and the impact of a burgeoning middle class in the developing world have all raised concerns about the spectre of inflation. Some economists have even argued for a temporary increase in the acceptable level of inflation to mitigate the effects of further debt deleveraging.
In this environment, investors should consider the merits of commodities as a hedge against inflation. Instead of passive index replication, however, strategies that allow active managers to capture the commodity risk premium have the potential to increase risk-adjusted returns.
Historically, portfolios consisting of stocks and bonds have performed poorly in real terms when inflation has been rising. In contrast, a basket of commodity futures represented, for example, by the S&P GSCI Total Return index, performs best in inflationary environments. That should come as no surprise since commodities provide the basic inputs for many of the goods whose prices are used to calculate inflation. It is interesting to note that commodities also perform well when inflation is stable.
In his 1930 ‘Treatise on Money' John Maynard Keynes highlighted the existence of a commodity risk premium in his theory of ‘normal backwardation'. According to Keynes a commodity's futures price should be less than the expected spot price in the future.
Why? Because commodity producers seek to use futures to hedge their price risk and need to offer investors an incentive for supplying this insurance. By going long a futures contract at a discount to the expected spot price, investors should achieve a positive excess return as the futures price converges to the spot price over time.
Nicholas Kaldor's ‘theory of storage', from 1939, is an alternative view on the existence of a commodity risk premium. It says that inventories are held to mitigate the risk of a disruption in supplies and that if they reach a low enough level, the threat of a stock-out increases, as does the likelihood of price volatility - and that futures are therefore a form of insurance against price volatility. Like any type of insurance, it will cost more when risks are elevated. Since commodity futures markets can protect against price volatility, expected risk premiums should be negatively correlated with inventory levels. In other words, low inventories should equate to higher expected risk premiums.
In passive investing, the most commonly followed commodity indices are the S&P GSCI index and Dow Jones-UBS Commodity index. These are set using either global production data (S&P) or a combination of global production and liquidity data (DJ-UBS).
Because the indices use factors other than risk and return to assign individual market weights and because investors should be able to extract a commodity risk premium, an active approach to commodity investing can potentially add value relative to a published commodity index.
Capitalising on supply and demand
The commodity markets are diverse and influenced by supply-and-demand dynamics unique to a particular sector or market. Given that it takes a long time to bring new sources of supply to market (for example, a new mine or deep-water oil discovery), structural imbalances may persist for extended periods. In addition, companies have an economic incentive to hedge their operating margins, thereby offering speculators an opportunity to profit from assuming future price risk. Risk premiums may also be obtained in markets exhibiting low inventory levels.
Mitigating downside volatility
Investors who allocate capital to strategies that replicate and track the popular commodity indices cannot exit or sell short in downward trending markets. Starting in June 1997, the DJ-UBS Index experienced a drawdown lasting 21 months, with a peak-to-trough loss of 36.2%. It then took 18 months for the index to make a full recovery. The importance of being able to allocate capital away from those markets leading the decline, or even to profit from their retreat through shorting, cannot be overstated.
Dealing with markets in contango
Over the recent past, a number of commodity markets have been trading in a state of contango, where the term structure of their futures curves have been upward sloping, especially when looking at nearby contracts. Etched in investors' memories is the 2008 decline of spot WTI crude oil from a high of $146 a barrel in July to a low of $35 in December. The cost to roll forward in that market (selling out of a maturing contract and purchasing one with a later maturity date to maintain exposure) was extremely painful in November and December. Employing a roll strategy that is not beholden to the front and nearby contracts allows an active manager to select contracts further out on the futures curve that may help mitigate the effects of contango.
Diversification through rebalancing
Commodity markets are highly heterogeneous. Supply and demand in one sector may differ from another, and the spread between the best and worst-performing commodity in a given year is typically very wide. This leads to low correlation among sectors and provides managers with the ability to allocate capital among and within sectors to capture some of this dispersion. Actively rebalancing a portfolio allows managers to obtain a diversification return, whereby the portfolio's compound return is greater than the weighted average compound return of the individual portfolio constituents. Neither of the published commodity benchmarks rebalances during the year.
Commodities offer investors the potential to hedge price risks associated with periods of rising inflation and to enhance returns by capitalising on the commodity risk premium. An active approach to managing commodity investments has significant advantages over passive investing. Investors can exploit the roll periods of published benchmarks, rebalance portfolios to take advantage of the dispersion in commodity returns, and, crucially, adjust a portfolio's overall net exposure to preserve capital during drawdowns.
Brent Bell is a vice-president and member of the Investment Solutions Group (ISG) at State Street Global Advisors