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COLUMN-Facts and fantasies about commodities (revisited): Kemp
January 8, 2015 / 11:19 AM / in 3 years

COLUMN-Facts and fantasies about commodities (revisited): Kemp

(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, Jan 8 (Reuters) - Commodities were the worst performing asset class for the third year running in 2014.

Investors, including some of the world’s largest pension funds, have seen billions of dollars of wealth disappear as a result of investing in commodity index products over the last decade.

So it is essential to understand what went wrong to help prevent a similar problem recurring in future.

“Facts and fantasies about commodity futures,” first published in 2004 by Gary Gorton and Geert Rouwenhorst, proved one of the most influential research papers in 21st century finance.

It provided the intellectual underpinning for the investment boom in commodity derivatives which followed over the next eight years until roughly 2012.

Gorton and Rouwenhorst concluded “the risk premium on commodity futures is essentially the same as equities” and better than bonds.

“In addition to offering high returns, the historical risk of an investment in commodity futures has been relatively low” and “they are an attractive asset class to diversify traditional portfolios of stocks and bonds.”

Yet all of those propositions have come under scrutiny as returns on commodity index products have disappointed investors over the last three years and in some cases longer.

Several high-profile investors and commodity index fund operators have recently closed down their operations citing returns which failed to match the complexity and risk involved in running the programmes.

PAST PERFORMANCE

“Facts and fantasies” was based on an analysis of returns that would have been available to an investor in an equally-weighted index of commodity futures fully collateralised by U.S. Treasury bonds between July 1959 and March 2004 (NBER Working Paper 10595).

“Facts and fantasies,” and similar papers written later by others, played a pivotal role popularising investment in commodities and making commodity indices respectable for a much wider group of investors.

Previously, commodity investment was the preserve of investors and hedge funds with a high appetite for risk and willingness to endure volatility.

“Facts and fantasies” helped convince even conservative investors, such as pension funds, that commodity derivatives, especially indices, were a prudent addition to their portfolios.

Commodity derivatives were not just a directional bet on boom-bust but an “asset class” that could be a source of long-term returns across the business cycle.

DISAPPOINTING RETURNS

Initially, the performance of commodity indices was in line with the historical research, and even exceeded expectations. Commodity indices soared between early 2002 and July 2008.

Hit-hard when the global financial crisis intensified in third quarter of 2008, they staged a moderate comeback in 2009, 2010 and 2011. Since then, however, performance has been consistently disappointing, as the attached charts illustrates (link.reuters.com/wyq73w).

Between June 2004 and June 2014, the compound annual growth rate (CAGR) for the S&P Goldman Sachs Commodity Index (GSCI) was -1.8 percent. The Light Energy and Non-Energy versions of the GSCI performed little better, eking out meagre returns of +1 percent and +2 percent per year respectively.

By Dec 23, however, returns on the GSCI averaged -3.7 percent per year since the middle of 2004, -1.3 percent for the Light Energy version, and just +1.2 percent for the Non-Energy variant.

Returns have been poor compared with stocks. The S&P 500 equity index achieved total returns of around +7 percent per year between June 2004 and June 2014, increasing to about +7.9 percent by December 2014.

In practice, commodity derivatives have exhibited all of the volatility of other asset classes (and often more) but none of the returns.

WHAT EXACTLY WENT WRONG?

The most widely invested commodity indices were the two families known originally as the GSCI and the Dow Jones AIG index. Both have changed ownership and been rebranded over time and are now controlled by Dow Jones S&P Indices and Bloombeg Indexes respectively.

None of the most commonly tracked benchmarks is an exact replica of the equal-weighted basket of commodity futures analysed by Gorton and Rouwenhorst between 1959 and 2004.

For all sorts of reasons, not least the small scale of some futures contracts, it is difficult to exactly replicate the “Facts and fantasies” type index as an investable index in the real world.

Most index families, but especially the main GSCI, are heavily weighted towards petroleum futures (crude oil, gasoline and distillate fuel oil), which tends to limit their diversification.

But the fact most commodity indices have produced similarly disappointing returns since 2004, including variants with a much lighter weighting towards crude oil and refined fuels, suggests index composition and the process for rolling maturing contracts forward on its own cannot explain the poor performance.

There is a tendency in the financial services industry to celebrate successful products and try to quickly forget the unsuccessful ones: why dwell on the failures of the past?

VANISHING RISK PREMIUM

The basic explanations for the poor performance of the indices can be recounted easily enough. Index returns comprise three components: (1) the spot price of the commodity; (2) the yield from the Treasury securities used as collateral; and (3) the roll return from swapping a position in maturing contracts into longer dated ones.

The problem with spot prices is obvious given the fading of the so-called “super-cycle” and the decline in prices for a broad-range of commodities.

But the case for investing in commodities, and treating commodity derivatives as an asset class, was never supposed to rely on rising spot prices, a point which “Facts and fantasies” makes clear.

The problem with the collateral yield is also obvious. Near-zero official interest rates and low bond yields have sapped reported commodity index returns.

In practice, many investors will have done better than benchmark indices because they are invested in a range of bonds, not just Treasuries. Nonetheless there is no denying that returns on commodity-derivative related products have been disappointing.

The real problem has come from the roll yield, or more precisely the idea that the price of a basket of commodity futures contracts should tend to rise over time to compensate investors for assuming price risk from commodity producers.

There are various ways of characterising this type of return. John Maynard Keynes called it “normal backwardation”. Gorton and Rouwenhorst call it a “risk premium”.

Because of this risk premium, Gorton and Rouwenhorst showed the holder of a fully collateralised basket of commodity futures would have obtained a much higher rate of return than simply the spot price of the commodities between 1959 and 2004.

Rather than compensating investors for taking a risk on the future direction of prices, broad-based commodity indices have actually charged them for the “privilege”.

So what changed between 1959-2004 and 2004-2014? The most obvious answer is that it was the popularity of commodities as an asset class, and the influx of new investment as a result, which transformed the way futures prices behaved.

Prior to 2004, and especially prior to the early 1990s, commodity derivatives markets were small and illiquid. For much of the 1959-2004 period, there were no futures markets for important commodities like crude oil and U.S. natural gas.

In small and illiquid markets there might well have been a substantial risk premium for investors but it seems to have vanished once markets became more heavily traded. The 1959-2004 period may not have been very representative of the long-run returns that investors can actually achieve by investing in commodity derivatives.

It would be useful to update “Facts and fantasies” to see if the results are robust for the entire period from 1959 to 2014, and if estimates for the risk premium are sensitive to the exclusion of certain sub-periods (eg 1959-1979 or 1994-2014).

In an email, Gorton told Reuters he and Rouwenhorst are working on an update of the original paper, since ten years have passed, and plan to release in it in the usual academic way.

In the meantime, the mistake made by investors and the banks which sold index products was to assume historic returns would be available in future once commodities moved from a niche product into the mainstream.

The experience of the past decade strongly suggests the answer is No. (Editing by William Hardy)

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