By John Kemp
LONDON Jan 30 Investors' enthusiasm for
commodity indices and other investment products has supported a
huge expansion in banks' commodity desks as well as the number
of specialist commodity funds and hedge funds. The question is
whether it can be sustained if returns do not start to improve.
The best columns begin with a chart. This one starts with a
graph showing excess returns on the Standard and Poor's Goldman
Sachs Light Energy Index since 1970:
The chart uses the light energy index because it
restricts the weight given to crude and refined products and is
more representative of a diversified basket of commodity futures
It focuses on excess returns excluding the yield on
Treasuries held as collateral because that is the commodity part
of investing in a commodity index. It is what investors are
buying when they choose to allocate money to a commodity
product. If they wanted the bond part of total returns, they
could keep their money in a bond index.
The chart tells the story of the rollercoaster ride in
commodity prices, markets and investing over four decades.
Excess returns have been variable. The super-cycle between
November 2001 and June 2008 stands out clearly. But it came at
the end of a long-period of 30 years (1973-2004) when average
returns were basically zero (Chart 2).
Actual performance for investors has been lower. Returns
shown in the chart take no account of the impact of inflation
and management fees.
THE $400 BILLION QUESTION(S)
Confronted with this chart, pension funds and their advisers
must answer two questions -- one specific, the other more
(1) Specifically, is now the time to make an allocation to
commodities for new investors, or boost weightings for
institutions that have entered the asset class already?
The excess return index stands close to its four-decade
average level. Do current conditions resemble 2003-2004, when
commodity markets were on the threshold of an explosive rally,
fuelled by cheap money, emerging market demand and supply chain
bottlenecks? Or are conditions more similar to 1975-2003, when
excess returns were negligible over the medium and long-term?
(2) Generally, is holding a diversified basket of commodity
futures and swaps as part of a wider portfolio including
equities, bonds and other assets the best way to capture
risk-adjusted returns and participate in the economic shifts
taking place as a result of industrialisation in China and other
IS THE SUPER-CYCLE PEAKING?
The charts suggest difficult answers to those questions for
both pension fund managers and commodity professionals.
The current position of commodity markets bears a strong
resemblance to conditions in 2003-2004, which might suggest
prices are poised for another explosive spike upwards. The
global economy is emerging from a slowdown. Interest rates are
low. Expanding demand should tighten supply-demand balances in
the years ahead and could push prices higher.
But there are also important differences. Global consumption
of key raw materials such as crude oil, copper, steel and grains
has already surpassed the previous peak set in 2008. Yet prices
in many cases are up to a third lower, as the supply side of the
markets has begun to respond to the incentives provided by
The question for institutions and their advisers is whether
2008 marked a temporary setback in a multi-decade uptrend, or
the maturing of the super-cycle as the supply response finally
began to catch up.
LONG-TERM FUTURES RETURNS
The more general question is equally uncomfortable.
Economists from John Maynard Keynes and Harold Hotelling in the
1930s to Gary Gorton and Geert Rouwenhorst in the 2000s have
suggested there must be an incentive for investors (in
aggregate) to shoulder price risk for hedgers. From the charts,
however, it appears there may be little or no long-term excess
return from just holding a diversified basket of commodity
In their paper on "Facts and Fantasies about Commodity
Futures", Gorton and Rouwenhorst found there were excess returns
on holding a fully collateralised, equal-weighted basket of
commodity futures between 1959 and 2004, similar to the equity
risk premium. Gorton and Rouwenhorst argued this was a risk
premium commodity investors could capture for taking price risk
on behalf of producers and consumers.
But the premium appears to have evaporated shortly after the
paper was published. The charts suggest the existence of the
premium is quite sensitive to the time period over which it is
measured. There have been long periods, in some cases lasting
decades, in which investors were not rewarded for shouldering
risk via futures and options in this way.
The phenomenal out-performance of commodity prices between
2002 and 2008 may have caused institutions to over-estimate the
true long-term returns on futures contracts. In reality, most
returns in commodity markets appear to be returns to skill
(hedge-fund like timing of entry and exit based on market
fundamentals and narratives) rather than captured via index-like
The problem is that most studies show hedge fund operators
have captured almost all the benefits for themselves through
performance and especially management fees. Average returns for
clients have been low, as industry veteran Simon Lack explained
in an article for the "AllAboutAlpha" website last week ("Do
hedge funds work?").
CLIENTS PUSH BACK ON FEES
Some clients have started to complain about the high-level
of fees paid for average performance. South Carolina's public
pension funds have been among the most enthusiastic adopters of
alternative investments, but the state is now starting to
reassess its strategy.
The $26 billion state retirement system held almost half its
assets in alternative investments by mid-2011 -- including a 1.9
percent weighting to commodities as well as 11.1 percent in
opportunistic credit, 6.8 percent in private equity, and 8.1
percent in opportunistic alpha hedge funds according to the
latest quarterly report of the South Carolina Investment
Only a fraction of South Carolina's pension funds have been
allocated to commodity derivatives. But the state treasurer has
complained about (relative) underperformance and the high level
of fees, which climbed 11 percent to $344 million in 2011, even
though the funds' performance was below average, according a
thoughtful analysis published in the Wall Street Journal
("Weaning Off Alternative Investments", Jan 30).
"There is no question our returns would have been higher in
the past decade if we had stayed in fixed income," according to
the chairman of the pension investment commission, though he
adds: "I doubt that will be the case over the next decade".