Can Commodities Still Pound Away at the Old Enemy?

We take a fresh look at commodities' rep for fighting market downturns and inflation.

Arijit Dutta 20 August, 2009 | 0:00
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Global markets have had a nice recovery in recent months, but investors are still struggling to reconcile the many long-held investing beliefs that came into serious question during the bear market between October 2007 and March 2009. Possibly the most disturbing example is the crisis of confidence in the idea of diversification itself. Just about everything other than the safest government bonds got slaughtered last year, leaving many investors wondering if the old notions are broken.

Commodities are one asset class that has faced some particularly biting questions. The much touted diversification benefits of commodity investing apparently proved false: Most commodity indexes matched or fared even worse than the S&P 500 Index's 37% loss in 2008. Funds in Morningstar's natural-resources category in fact suffered a brutal 48% slump, on average, last year. It'll take a long while indeed to make up those kinds of losses.

Is there still long-term investment justification for commodities after those results? The short answer is yes, but the question is fairly nuanced so let's peel through its layers.

Click here to view the table.

What's a Commodity Fund Anyway?
The first key point to note is that a vast majority of funds in the natural-resources category don't quite provide pure commodity exposure. They invest primarily in stocks of companies that produce or process commodities such as agricultural and industrial raw materials and precious metals. That means the funds are exposed to things like corporate managements and other equity market factors, not just commodity prices (thought they can be important as well). What complicates things even more is that these companies often hedge against commodity price fluctuations in order to make their revenues more predictable. But such hedging can all but defeat the purpose for investors seeking exposure to commodity prices. Overall, as shown in the attached table, natural-resources funds have a high-equity market beta, which means you cannot typically expect much protection when stocks are in trouble. These funds' high correlation with the market is also captured by their relatively high average R-squared.

Instead, funds that invest in commodity futures are a much more direct play. These funds use various derivatives like futures, swaps, and notes to gain exposure to the commodity index of their choice. This can be done with only a tiny fraction of fund assets, so the rest of the cash is pledged as collateral and can be either invested in short-term Treasury bills or other fixed-income securities at the fund manager's discretion. In theory at least (I'll say more on this later), this should result in returns that closely track fluctuations in commodity prices, and minimize equity market exposure. Indeed, the average beta and R-squared of commodity futures mutual funds and exchange-traded funds are much lower than the overall averages we noted earlier for natural-resources funds. As shown in the table, however, these average betas and R-squareds are still significantly higher than those of most commodity indexes. That important observation leads us to the next key topic.

Active vs. Passive
Just like stock and bond funds, commodity futures funds can be either actively managed or follow a passive strategy. Passive fund managers choose to roll with the index. Literally. In the process described above, these managers "roll" their futures contracts when they are close to maturity into the nearest contracts, as prescribed by their benchmarks. So, if the manager has a futures contract in the portfolio that obliges him to take delivery of a set amount of crude oil in August, he will simply sell that contract before the end of the month and buy a new contract for end-of-September delivery. Moreover, the cash collateral is also managed strictly as in the index construction, in short-dated Treasury bills.

Active managers, on the other hand, may deviate at various points in the process. For example, Oppenheimer Commodity Total Return Strategy will over- or underweight specific commodities based on management's assessment of relative value. Management at PIMCO Commodity RealReturn Strategy doesn't bet on individual commodities, but may alter the contracts' roll schedule if the nearest contracts seem richly priced. And PIMCO also uses its fixed-income expertise to add value through active management of the cash collateral by using TIPS and other securities than can potentially outpace T-bills.

It's also important to note that commodity indexes display more variety in their construction than stock or bond indexes, so they can have sharply different risk-return characteristics, at least in the short run. The S&P GSCI Index has a much bigger allocation to energy commodities than the DJ UBS Commodity Index, for example. Thus, choosing a commodity benchmark can itself be an "active" decision of sorts.

Just like in stocks and bonds, the active versus passive debate is far from settled in the commodity space. Commodity prices are inherently volatile, but some managers may employ a credible, valuation-conscious approach to make active bets. There is just as much controversy over whether any active manager can spot mispricings in futures contracts, which calls into question any strategy based on varying roll schedules. Some studies, however, have found evidence of outperformance among managed futures strategies that are available to high net-worth and institutional investors. These managers have the flexibility to go long or short commodity futures based on relative valuation or sizable mispricing in futures prices. The Morningstar Long/Short Index aims to benchmark such practices. As shown in the table, that index has a negative short- and long-term market beta and actually posted a double-digit gain past year. To learn more about how and why roll schedules can affect returns in futures strategies, take a look at this article.

Thus, also similar to other asset classes, the decision to choose an active or passive fund ultimately depends on personal bias and availability to some extent. If you are inclined toward the active camp and can gain access to a good active manager at an attractive expense ratio, great. (For example, Harbor Commodity Real Return is run by the same team as the aforementioned PIMCO fund but is available at a cheaper cost. If not, go for a cheap ETF or other passive option. (Check out PowerShares DB Commodity Index, for example.) Be careful to study the risk-reward characteristics of the fund's chosen benchmark, though, and beware of funds that use leverage.

The Long-Term Case
We've sorted through some useful detail, but let's now deal with the broader question of whether commodities belong in most investors' long-term asset-allocation plan.

Last year's debacle justifies the criticism of some market observers who had been ringing alarm bells during the tremendous bull market that extended well into the first half of 2008. The argument goes that the sheer number of investors who have made room for commodities in their portfolios in recent years (some were drawn by the diversification idea, and many were just good old performance chasers) has turned commodities from being a physical asset to being just like other financial assets like stocks and bonds. This means commodities are likely to boom and bust more in tandem with the broader market. That logic undermines the case for strategic, long-term allocation to commodities.

But I think it would be harsh to throw out all previous studies of commodity performance on account of one extraordinarily shock-prone year. Many studies have found empirical evidence of attractive risk-adjusted returns in commodities, and downside protection from the broader market to boot. There are fundamental reasons as well for that pattern to hold. Just as equity investors get paid over time for funding the economy's productive capacity and bond investors earn the time value of money, commodity futures investors should expect a reasonable payment for providing insurance to commercial producers and consumers of commodities who need to hedge their exposure to fluctuating commodity prices. This also means the sources of return are fundamentally different for commodities, which suggests they should continue to be good diversifiers of stocks and bonds. And commodities are components of the general price level, so they should also continue to be inherently inflation-proof. Even over the past year's severe market turmoil, commodities have gone up when inflation expectations have risen.

The table in this article does indeed show that most commodity indexes still sport attractive low long-term betas and R-squareds even after the damage from last year. The old caveat against performance-chasing still stands, but a limited allocation to serve as an inflation and a market risk hedge is still quite justifiable. One added suggestion is to be somewhat "tactical," or be responsive to valuations, as is generally being recommended these days. This could just mean timely rebalancing, which would have led to timely profit-taking, and lessened the pain last year. As a related example, take a peek at the newly launched PIMCO Global Multi-Asset The fund uses a vast range of derivatives and options to gain exposure to a large number of asset classes from stocks and bonds to commodities and real estate. The really interesting part of the strategy though is the cutting edge technique called "tail-risk hedging" management uses to hedge the portfolio from the risk of extreme losses. This sounds great in principle, and the tremendous expertise and experience at PIMCO in the area bodes well for the approach to work out in practice as well.

Final Word
Don't lose sight of the asset class' fundamental merits because of what happened last year. There are a few good, reasonably priced natural-resources funds where management can identify solid companies, but your best bet for long-term strategic allocation to commodity prices is through a futures fund. Cheap, passive futures funds and those that seek to add a modest amount of value through active management are both valid options to consider.

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Arijit Dutta  Arijit Dutta is an associate director of mutual fund analysis with Morningstar.

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