For most passive commodities investors, 2006 was a disappointing year in performance terms. But instead of a knee-jerk response, reducing its exposure to this asset class, the reaction from Doctors Pension Fund Services was a calm reappraisal of its whole approach to this area.

New active strategies went live at the end of March this year, and the fund has been rewarded with realised alpha of 3% over the following five months. Moreover, good portfolio structuring has meant that the average risk budget was only 3.5%.

It was at the end of last year that DPFS decided to re-examine its passive investments in commodities, and pinpoint the reason for the underperformance. The fund wanted to find out whether it was because a situation of structural contango (near-dated discounts) had made the long-term fundamentals really unattractive. An alternative explanation was that the standard commodities indices had delivered an inefficient beta for this specific environment.

The pension fund had recently recruited a number of staff who were highly experienced in active investing in commodities. This team started studying alternative ways in which the risk/return profile of the asset class could be improved.

As a result of intensive back-testing, the team came to the conclusion that a combination of smarter beta replication and active overlays would generate much higher returns per unit of volatility.

They also concluded that commodities remain a very attractive investment, even in periods of structural contango. As long as the rolling costs in periods of strong contango are mitigated, the long-term themes of structural underinvestment, the strong growth of emerging economies and supply/demand imbalances will drive commodities returns.

In early 2007, the first major decision resulting from this study was made. DPFS decided that it did not need to lower its strategic weight in commodities. Instead, it started a process to structure the portfolio more efficiently.

The passive commodities portfolio had previously been managed externally. The newly-recruited three-person investment team, plus one trader, now started to upgrade the operational systems and risk management tools, and made preparations for the pension fund to invest in futures, swaps and options. However, the S&P GSCI commodities index was retained as the benchmark.

Encouraged by strong back-tested results, and confident about its investment experience, the team now requested a high-risk budget, equal to 6% ex-post tracking error. While this appears to make the pension fund one of the less risk-averse institutional commodity investors, the unique selling point is that the expected return per unit of risk improves dramatically. This applies on a stand-alone basis and within the ALM context.

There is still, however, the major question of what sources of alpha the team can perceive, and how these alpha ideas can be transferred in a highly efficient portfolio structure.

The first two building blocks for this are two replicating strategies that deliver a smarter beta than the S&P GSCI index. One strategy is to optimise the commodities weighting per sector by exploiting the strong fundamental relationship between  backwardation, inventories and spot commodities returns. A typical investment theme is to exclude exposure to the most volatile commodity of all - natural gas - and hedge this position with other highly-correlated forms of energy.

A complementary strategy is to attain smart beta by optimising the term structure. This means that per single spot contracts are replaced by longer-dated contracts whenever the trade-off between rolling cost and volatility is attractive. Term structures are influenced mostly by seasonal patterns, which create opportunities for more efficient rolls in commodities such as wheat and cattle.

It is important to note that the strength of this approach lies not in good timing skills, or having strong directional views. Instead, it lies simply in the structuring of more efficient portfolios by implementing sophisticated portfolio management techniques.
In addition to smart beta strategies, the pension fund employs tactical overlays that play fundamental themes or temporary misvaluations within sectors. One example of this is to trade Kansas wheat against Chicago wheat. Normally, these types of overlays have a low correlation with the beta blocks, and do not consume high-risk budgets.

The final - and very promising - building block is the use of option strategies, either to sell volatility (grasping the high premiums for commodities) or to further diversify the risk structure of the beta pools.

Given the extreme volatility of commodities as an asset class, it became obvious that very simple systematic and rules-based strategies were as effective - or even more effective - as trying to develop highly accurate forecasts.

This is because in addition to the quantitative tools to monitor and steer the risk profile, good risk management also requires the fund to continually set out stress scenarios, with fundamental analyses of how the portfolio would perform under certain extreme

According to DPFS, this also explains why the ultimate step into highly-leveraged (fund of) hedge funds does not look particularly promising. Most hedge funds cannot take extremely leveraged long-term positions. In addition, the high fees which are charged, and the tendency to restrict funds to single sectors, makes it hard to benchmark hedge funds against the GSCI.

At present, DPFS is still optimistic about the long-term value and risk characteristics of commodities. With hindsight, the team has been proved right not to have reduced the fund's commodities exposure at the end of 2006.

In the face of poor performance from its commodities portfolio, DPFS did not panic and pull out of the asset class. Instead, it used its experienced internal team to find out the reasons and create a plan for successful investing. The team concluded that commodities were still an attractive long-term investment, but that better returns per unit of volatility could be achieved by smarter beta replication and active overlays.

Commodities now have the same weighting as before within the fund's portfolio, but different techniques are used to optimise returns by exploiting relationships between fundamentals, optimising term structures, and using option strategies. DPFS has, however, decided to avoid highly-leveraged hedge funds.

Since their inception earlier this year, these strategies have earned the fund a realised alpha of 3% with an average risk budget of only 3.5%.