Seeking a Smarter Solution in Commodities

Transcription

1 Seeking a Smarter Solution in Commodities HAKAN KAYA, PHD PORTFOLIO MANAGER VANESSA ROSENTHAL PRODUCT SPECIALIST ANURADHA MATHUR PRODUCT SPECIALIST JANUARY 204 From energy that powers cars and homes, to raw materials that are used to create infrastructure, to our most basic needs such as the food that sustains us, commodities are an essential part of our daily lives. Over many years, markets have developed around the world to facilitate a variety of needs and transactions between commodity suppliers, consumers and investors. Today, commodities are a tremendously important part of the world s economy, with global production value exceeding several trillion dollars. In this paper, we discuss what we believe are the benefits of this unique asset class, detail ways that investors can access commodities and unravel the weaknesses in the so-called passive commodity indices. Finally, we put forth what we think is a more intuitive, smarter approach for investors to consider as they seek exposure to the asset class. THE ROLE OF COMMODITIES IN A PORTFOLIO We believe commodities is a unique asset class, with the underlying individual markets driven by their respective supply and demand trends. These forces are quite different from the factors that influence other asset classes such as stocks and bonds, which, in turn, result in a commodities return and risk profile that is also quite unique (historically, commodities have exhibited low to negative correlation when compared to traditional stock and bond investments). Given that global growth and consumption patterns are among the broad range of factors that may influence individual commodity prices, there is also diversification within the asset class, among the various commodities constituents. For example, consider that the price of crude oil can be significantly altered due to political instability in an oil-producing country, while corn prices could undergo wild swings as 72 weather affects 30the 67 crop 00 yield forecast This 00is one 55 of 55 the keys 00to 00 diversification bringing in something that zigs when everything else zags can help manage portfolio risk over time, dampen drawdowns and potentially improve long-term returns. Although in isolation, commodities have historically demonstrated volatility on par with equities, the addition of commodities to a portfolio has the potential to lower overall portfolio risk, thereby increasing the portfolio s Sharpe ratio (risk-adjusted return), while potentially providing a hedge to inflation. C 60 M 30 0 K 30 While some may argue that the commodities supercycle is over, we believe that the case for commodities remains clear. Global population projections forecast consistent year-overyear growth 2 over the next several decades and the implications of that growth will include greater demand for the raw materials that will feed, transport, sustain and house these increasing populations. Additionally, although technology is evolving to make production across various industries more cost efficient, research suggests that supply side costs continue to increase, putting a floor under commodity prices. 3 What is the role of commodity investment funds and how do they behave? (n.d., paragraph 5). In FAQs. Retrieved from 2 PwC Economics (203). World in 2050: The BRICs and beyond: prospects, challenges and opportunities. Retrieved from 3 McKinsey Global Institute (203). Resource Revolution: Tracking global commodity markets: Trends Survey 203.Retrieved from

2 EFFICIENT EXPOSURE One of the most efficient ways to get exposure to commodities is through futures contracts, which represent an agreement to buy or sell a specific quantity of a certain commodity at a future date and price. As a contract approaches its expiration, it can be rolled into another contract with a longer expiration, avoiding a herd of cattle being delivered on the doorstep. Futures contracts are widely considered to be cash efficient, liquid and effective for investment and risk management purposes. Furthermore, gaining exposure to a broad basket of commodities via futures contracts is quite standard for the asset class. FIGURE : COMMODITIES MAY BE ABLE TO IMPROVE AN INVESTOR S EFFICIENCY Investor's Expected Return 2% % 0% 9% 8% 7% 6% 5% Without Commodities With Commodities % 2% 3% 4% 5% 6% 7% 8% 9% 0% % 2% 3% 4% 5% Investor's Risk Level Sources: Bloomberg, Ibbotson, Neuberger Berman s Quantitative Investment Group. Data analysis from This hypothetical portfolio assumes an allocation to large and small company stocks, long-term corporate bonds, long- and intermediate-term government bonds and Treasury bills as defined by Ibbotson SBBI Classic Yearbook. Commodities allocation assumed to be 0% as measured by the S&P GSCI. The hypothetical portfolio described above does not represent any Neuberger Berman managed account or product. Expected returns are solely for portfolio construction purposes. The expected return does not represent the final output of the model, nor is it intended as an estimate of the investment return of the strategy. Investing in Commodities Assuming one is convinced of the benefits of commodities, the next logical question is to decide how to get exposure to the asset class. Several options can provide some exposure, but in many cases such exposure is indirect, costly, or comes with additional undesirable risks. Physical ownership of a diverse set of commodities is typically unrealistic due to the cost and complexity of transportation, storage and illiquidity. While storing physical gold or other precious metals might be relatively more feasible, physical ownership of most other commodities is generally not practical. Another option is commodity-related equities, such as the shares of a mining company or a refining company; these may provide some exposure to the underlying commodity, but they can also leave investors vulnerable to broad equity market movements as well as company-specific risks, such as how effectively management runs the company or country risk if the company operates in an area where the regulatory regime is not fully developed. Finally, managed futures strategies are often associated with commodities investing given the similar instruments in which they invest, but it is important to understand the underpinnings and objectives of such strategies. Generally speaking, managed futures are run by active managers known as Commodity Trading Advisors (CTAs) and are often based on trend-following models, with the ability to go long or short various assets in an effort to produce absolute returns. Of particular note to the discussion here, managed futures invest in a wide variety of asset classes not just commodities including futures on equity indexes, government bonds, interest rates and foreign currencies. As a result, managed futures generally should not be considered as a means to gain diversified exposure to tangible commodities. 2

3 In fact, we believe that none of these options is effective in delivering the overall portfolio benefits of commodities. In fact, these benefits are based on analysis that includes an allocation to a broadly diversified basket of commodities, which leads us to a discussion of investment vehicles that provide such exposure, such as commodity indices. The so-called passive commodity index providers have produced benchmarks that use a range of selection methodologies to mimic the commodities market. The two major commodity indices the S&P Goldman Sachs Commodity Index (S&P GSCI) and the Dow-Jones UBS Commodity Index (DJ-UBSCI) use rule-based approaches considering factors such as global production and trading volume, while other indices base their weights on the discretionary views of a committee. The range of resulting benchmarks demonstrates that not all indices are created equally these benchmarks come with dramatically different weighting outcomes, return profiles and risk consequences. In fact, the tracking error, which is a measure of how much two return series differ from each other, between the S&P GSCI and the DJ-UBSCI is more than % relative to one another. 4 As a comparison, the tracking error between the S&P 500 Index and the Russell 000 is around 0.8%. 5 This demonstrates the considerable differences from one commodity benchmark to another, begging the question of which is the right benchmark to broadly track commodities markets. Given that there are so many products linked to commodity indices, such as mutual funds or ETFs (see Pass on the Passive ), or geared around these benchmarks in some way, it is worth digging a bit deeper into the indices to better understand what an investor is hitching his or her wagon to. In the equity world, many major indices are weighted using market capitalization. This concept, however, does not apply to commodities, because one cannot determine the market capitalization of a commodity. For example, what is the market cap of oil? Should we use proven reserves, or just the last few years of production? How about reserves that are not revealed to market participants by some countries? These and many other potential questions make the notion of market capitalization weighting very elusive in the commodity universe. 4 Source: Bloomberg, using data from January 200 December Source: Bloomberg, using data from January 200 December

4 PASS ON THE PASSIVE Passive investing in any asset class often means investing in an index-linked fund, typically through a mutual fund or inexpensive exchange-traded fund (ETF). Generally, these index-linked funds closely replicate a widely recognized benchmark. In equities, for example, ETFs might track the S&P 500 Index or the Russell 000, which are comprised of the largest companies in the U.S. Similarly in commodities, the largest ETFs track various commodity indices as shown in Figure 2. Other more narrowly-defined ETFs might track a particular sector such as energy, or even an individual commodity such as gold or oil. In our view, all of these options fall short of providing diversified commodities exposure. In the case of the index-linked ETFs such as in Figure 2, we have already discussed what we believe to be the shortcomings of basing one s commodities exposure on indices. In the case of sector or individual commodity ETFs, we generally believe this is more of a tactical decision on the investor s part, rather than an effective means toward an end goal of accessing the portfolio benefits of a diversified commodities portfolio. FIGURE 2: TOP 5 COMMODITY ETFS/ETNS BY AUM Name Index/Sector Tracked Methodology of the Index Rebalance Frequency PowerShares DB Commodity Index Tracking (DBC) DBIQ Optimum Yield Diversified Commodity Index Excess Return Rules Based Maximize Potential Roll Returns (no Softs, Livestock) Annual ipath Dow Jones-UBS Commodity Index Total Return ETN (DJP) Dow Jones-UBS Commodity Index Rules Based Trading Activity & Production Data 2 Annual ishares S&P GSCI Commodity- Indexed Trust (GSG) S&P GSCI Rules Based World Production 3 Annual ELEMENTS Linked to the Rogers International Commodity Index Total Return (RJI) Rogers International Commodity Index Discretionary Committee World Consumption 4 Monthly The United States Commodity Index Fund (USCI) SummerHaven Dynamic Commodity Index Total Return Rules based Equal weighted (7 with greatest backwardation, 7 with greatest 2-month price increase) 5,6 Monthly Sources: Deutsche Bank (202). DBIQ Index Guide. Retrieved from 2 S&P Dow Jones Indices (203). Dow Jones-UBS CI SM Methodology. Retrieved from 3 S&P Dow Jones Indices (203). S&P GSCI Methodology. Retrieved from 4 Beeland Management Company, LLC (203). THE RICI Handbook. Retrieved from 5 The United States Commodity Funds, LLC (203). United States Commodity Index Fund. Retrieved from 6 SummerHaven Investment Management, LLC (203). SDCI Index Methodology. Retrieved from 4

5 As previously mentioned, some prominent commodity indices base constituent weights on global production and/or commodity trading volume. Advocates will contend that this method is analogous to market capitalization in equities, in that global production data largely captures the role a commodity plays in the global economy. Measuring production, however, is by no means an exact science and there are significant anomalies in reporting from region to region. Perhaps more importantly, we would argue that the productionbased rationale is somewhat counterintuitive because it notably doesn t value the scarcity of certain commodities. Consider the following two examples: Platinum is produced in low quantities relative to other commodities and, as a result, it does not qualify for inclusion in either the S&P GSCI or the DJ-UBSCI. That said, the price of platinum is around $,400 per ounce 6 and it is a critical element in the production of various industrial and automotive systems, so we would argue that its scarcity is an important component of its value. 7 Natural gas currently accounts for approximately 4% of the overall weight in the popular DJ-UBSCI, partly due to its recent production boom. However, as illustrated in Figure 3, the price of natural gas has plummeted since its peak in mid In this case, an investor would be prudent to remember the basics of supply and demand in considering whether a commodity in abundant supply, such as natural gas, should hold such a large allocation within a portfolio. Another limitation of the indices is that they are unmanaged. The major commodities indices, including the S&P GSCI and DJ-UBSCI, are rebalanced annually, which means that the constituent weights are left to drift over the course of the 2-month period, regardless of what happens in the underlying markets. This lack of active management can be potentially damaging, particularly in an asset class where certain markets can experience substantial volatility spikes. FIGURE 3: MONTHLY NATURAL GAS PRODUCTION VS. PRICES ($) U.S. Natural Gas Marketed Production (MMcf) 2,500,000 2,000,000,500,000,000, U.S. Natural Gas Wellhead Price (Dollars per Thousand Cubic Feet) U.S. Natural Gas Marketed Production (MMcf) U.S. Natural Gas Wellhead Price (Dollars per Thousand Cubic Feet) Source: U.S. Energy Information Administration ( EIA ). Production data from January 2000 September 203. Price data from January 2000 December 202 (latest from EIA). 6 Source: Kitco, data as of December This is not a recommendation to buy or sell any particular commodity. 5

6 In addition to these shortcomings, we believe one of the most significant issues with investing in products that are linked to commodity indices is that the indices do not consider how risky a commodity is in their weighting processes. Consider that in the global production weighted S&P GSCI, the energy sector represents around 60% of the index. Energy commodities also happen to be some of the most volatile constituents of the index, historically accounting for over 90% of the risk of the asset class. As Figure 4 illustrates, even the DJ-UBSCI, long considered the more diverse of the two major indices, has at times been dominated by the volatility of the energy sector. We believe that taking an active approach to managing this risk and its potential volatility drag 8 on a portfolio i.e., the farther you fall, the greater the necessary rebound to return to even can have a beneficial impact on future returns. FIGURE 4: SECTOR WEIGHTS AND RISK CONTRIBUTION OF TWO MAJOR COMMODITY INDICES S&P GOLDMAN SACHS COMMODITY INDEX (%) SECTOR WEIGHTS (%) RISK CONTRIBUTION Energy Ind. Metals Pre. Metals Agriculture Softs Livestock (%) SECTOR WEIGHTS DJ-UBS COMMODITY INDEX (%) RISK CONTRIBUTION Energy Ind. Metals Pre. Metals Agriculture Softs Livestock Sources: Bloomberg, Neuberger Berman Quantitative Investment Group. For illustrative purposes only. Data is from July 200 through December 203 because of availability and risk model calibration. 8 For example, a decline of 0% in a $00 investment to $90, requires a subsequent increase of % to return back to $00. A decline of 20% to $80, however, requires an increase of 25% to return to $00. 6

7 THE SMART BETA TREND In recent years, an array of products labeled under the catch-all, smart beta, have emerged, claiming to provide more efficient, diversified exposure to various asset classes. The concept, which can be summarized as an alternative weighting method to traditional indices, has gained a great deal of momentum among investors; institutional flows into the category over the next five years are estimated to be close to $9 trillion. 9 Part of the reason for this trend is investors growing dissatisfaction with the tradeoff between the risk and reward of market cap investments not having performed as anticipated in recent years. The smart beta idea can be applied to various asset classes including commodities, where we believe the major indices are weighted in an ill-conceived manner. Building a Smarter Solution With this information as background, we believe there is a better way to provide investors with consistent, strategic exposure to commodities in a more diversified way. FIGURE 5: RISK OF INDIVIDUAL COMMODITIES Sector/Commodity ENERGY Natural Gas Crude Oil Gasoline Brent Crude Heating Oil Gasoil INDUSTRIAL METALS Nickel Lead Zinc Copper Aluminum AGRICULTURE Corn Kansas Wheat Wheat Soy Meal Soybeans Soy Oil 0% 3 Year Annualized Standard Deviation 50% PRECIOUS METALS Silver Platinum Gold LIVESTOCK Lean Hogs Feeder Cattle Live Cattle SOFTS Cotton Cocoa Coffee Sugar 0% 0% 20% 30% 40% 50% Sources: Bloomberg, Neuberger Berman s Quantitative Investment Group. For illustrative purposes only. Risk based on 3 year annualized standard deviation, ending December Source: Marriage, M. (203, September 6). Smart beta bandwagon triggers alarm. Financial Times. Retrieved from 7

8 In an effort to avoid over-concentration in a particular commodity, or commodity sector, in our approach to investing in commodities, we consider how much risk each commodity contributes to the overall portfolio risk. To achieve this, we use proprietary models to assess volatility, tail risk and liquidity risk, allowing us to get a clearer picture of where the risk lies in the portfolio (see Figure 5 which illustrates the relative riskiness of various commodities). Our process also considers relative correlations and then weights each commodity in our portfolio such that we have balanced risk coming from each commodity. This risk-balancing approach is often referred to as risk parity. The net result is a strategy that manages volatility and seeks to provides a smoother ride in the long term. This component of the process is the Core strategy, as seen in Figure 6 below. On top of risk balancing, we understand that commodity markets are also influenced by a diverse set of factors, including macroeconomic factors, geopolitical events, weather and commodity-specific supply/demand factors. As such it is important to recognize that additional return can also be earned by tactically timing our exposure to various commodities. This component of the process is the Tactical strategy, as also seen in Figure 6 below. Coupling the longer-term, strategic exposures based on the risk parity concept with a short-to-medium-term tactical overlay based on an ongoing analysis of these factors brings together two important sources of potential return to the portfolio. As opposed to the major commodities indices, which are typically rebalanced annually and left to drift, the risk-balanced commodity strategy is actively rebalanced monthly, allowing the tactical views to change month to month depending on market conditions, and adding an important potential source of alpha to an investor s portfolio. FIGURE 6: OVERVIEW OF NEUBERGER BERMAN S RISK-BASED APPROACH TO COMMODITIES CORE STRATEGY Selects commodity weights using risk parity based approach so that risk contributions from each commodity are balanced Potential Benefits Limits the impact of any individual commodity on total portfolio risk May provide better downside protection Focuses on risk contribution by: Volatility Tail risk Liquidity TACTICAL STRATEGY Actively manages exposures by taking advantage of short- to-medium-term dislocations and opportunities Drivers Macroeconomic themes Value Price dynamics Pairwise relationships Additional value from contract selection FINAL PORTFOLIO Derived by combining risk balanced core weights with tactical views Designed to provide a diversified, long-only commodity portfolio 8

9 CONCLUSION When included in a portfolio of traditional asset classes such as stocks and bonds, commodities have the potential to increase the portfolio s overall return and Sharpe ratio as well as to lower its volatility. While there are multiple approaches to gain exposure to the asset class, we believe that index-linked products are tied to illogical methodologies that base their weightings on arguably counterintuitive concepts such as production or trading volume. Instead, we prefer to select our commodities exposures by considering risk contributions and balancing accordingly. Additionally, taking an active view on individual commodities throughout the course of the year provides another source of potential return to the strategy that index-linked products may leave on the table. In closing, we believe commodities can serve an important role in most investors portfolios, but it is also critical for investors to carefully consider the pros and cons of the different ways of participating in this asset class. 9

10 This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. This material has been issued for use by the following entities; in the U.S. and Canada by Neuberger Berman LLC, a U.S. registered investment advisor and broker-dealer and member FINRA/SIPC; in Europe, Latin America and the Middle East by Neuberger Berman Europe Limited, which is authorised and regulated by the UK Financial Conduct Authority and is registered in England and Wales, Lansdowne House, 57 Berkeley Square, London, WJ 6ER; in Australia by Neuberger Berman Australia Pty Ltd (ACN , AFS Licence No. 3940), which is licensed and regulated by the Australian Securities and Investments Commission to deal in, and to provide financial product advice for, certain financial products to wholesale clients; in Hong Kong by Neuberger Berman Asia Limited, which is licensed and regulated by the Hong Kong Securities and Futures Commission; in Singapore by Neuberger Berman Singapore Pte. Limited (Company No K), which currently operates under an exemption from licensing under the Financial Advisers Act (Chapter 0) of Singapore for marketing of collective investment schemes to institutional investors; in Taiwan to specific professional investors or financial institutions for internal use only by Neuberger Berman Taiwan Limited, which is licensed and regulated by the Financial Services Commission ( FSC ) and a separate entity and independently operated business, with FSC operating license no.:(02) FSC SICE no.0, and address at: 0F, No., Songzhi Road, Taipei, Telephone number: (02) ; and in Japan and Korea by Neuberger Berman East Asia Limited, which is authorized and regulated by the Financial Services Agency of Japan and the Financial Services Commission of Republic of Korea, respectively (please visit for additional disclosure items required under the Financial Instruments and Exchange Act of Japan). Except for the foregoing, this material is not intended for use or distribution within or aimed at the residents of any other country or jurisdiction. This document is not an advertisement and is not intended for public use or additional distribution in the following jurisdictions: Brunei, Thailand, Malaysia and China. No part of this document may be reproduced in any manner without the prior written permission of Neuberger Berman LLC. The Neuberger Berman name and logo are registered service marks of Neuberger Berman Group LLC. 0

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