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 (Chart 1).
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 general:
(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 emerging markets?
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 elevated values.
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 futures.
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 investments.
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 Commission ().
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".
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