26 August 2008, Financial Times Fund Management

Despite a mid-summer sell off that sliced more than 22 percent off a key benchmark, commodities have been performing extraordinarily well for quite some time. According to the Standard & Poors’ Goldman Sachs Commodity Index [S&P/GSCI], commodities are up more than 40 percent over the last year thru August 18. Five-year annualized returns topped 15 percent. And 10-year annualized returns were above 14 percent.

The index trounced the MSCI World Equity Index, whose total return was down 8.51 percent over the past year, up an annualized rate of 10.69 percent over the past five years, and 4.56 percent over the trailing decade.

With this kind of steady performance, most managers look to maintain some degree of hard asset exposure in diversified portfolios. Thomas M. Idzorek, CFA, director of research at the asset allocation advisory Ibbotson Associates, found that over the long term, commodities generated the highest returns of all investments while being minimally correlated to all major asset classes. He also saw that commodities were positively correlated to inflation, thus making them a good hedge against rising prices.

The key issue facing advisors looking for such exposure, however, is how to get it. If one sticks to the index approach, there are plenty of licensed products that track commodities. But unbeknownst to many, their holdings vary greatly and so do their performance. Over the past year, for instance, the S&P/GSCI outperformed the Dow Jones AIG Commodity Index [DJ-AIG] by nearly 24 percentage points. Thus, investors have to be careful when they think they are “buying the market.” In reality, each index is actually providing variations of the market.

What these indices do have in common is that don’t buy stocks of oil or metal producers, but rather long futures contracts of the actual commodities. They generate additional yield from collateral, typically invested in secure short-term government securities to meet margin calls in case contracts fall in value.

The S&P/GSCI benchmark is the oldest and most popular investable index that many mutual funds and ETFs have licensed. It is comprised of two dozen energy, industrial and precious metals, and agricultural-related commodities. It’s weighted by global production. This means a heavy tilt toward energy, which currently comprises three-quarters of the index. Such exposure is great when oil and natural gas prices are rising–disastrous when they are falling.

Alternatively, managers can turn to the DJ-AIG, UBS Bloomberg Constant Maturity Commodity [CMCI], Deutsche Bank Liquid Commodity, and the Rogers International Commodity Indices.

They vary in several important ways. First, they have different range of holdings and subsector weightings. For example, the UBS Bloomberg CMCI Index invests in 28 commodities, the Rogers Index follows 35, while the Deutsche Bank Index is in just six. Where the S&P/GSCI has concentrated exposure to energy [75 percent], the Dow Jones/AIG Commodity index limits any individual sector exposure to 33 percent. And this produces different levels of risk. Long-term annualized volatility of the S&P/GSCI is 19.92; for the DJ-AIG, it’s 13.44.

Second, while they are all invested in futures contracts that require little money down, the way in which collateral for these contracts are invested can vary, depending on the index or mutual fund manager discretion.

This is discernable in the difference between Excess and Total Returns. Gains from the contracts alone are regarded as Excess Return. Total Return is inclusive of collateral yield.

Most indices use 3-month Treasury bills. However, Mihir Worah, portfolio manager of the PIMCO Commodity Real Return Strategy Fund, which tracks the DJ-AIG Index, invests in inflation-linked Treasuries with an average maturity of five years via the Lehman Brothers TIPS Index. This meant that combination of Fed rate cuts and higher consumer price inflation over the past year propelled his collateral return up 10.1 percent versus 2.8 percent for 3-month Treasuries.

Moreover, Worah believes his fund offers a more complete inflation hedge than most other indices. “Commodity exposure provides protection at the wholesale price level,” he says, “while TIPS provide it on the retail CPI level.”

Third, maturity and management of the futures contracts also vary, affecting volatility and returns. S&P/GSCI relies generally on one month contracts while the UBS Bloomberg Constant Maturity Commodity Index goes out to three years. Gains or losses are generated from the underlying change in commodity prices and when contracts are rolled over. When futures near maturity, they are sold and replaced with longer dated contracts, a process that generates roll yield.

Traditional indices use set contract lengths that roll systematically. Newer variations seek to exploit alpha from greater contract management. For example, Kurt Nelson, head of US Commodity Index marketing at UBS, argues that contracts which are swapped daily for longer dated futures avoids the impact speculative activity that can affect monthly rolls of traditional indices. Daily rollover, he says, “minimizes exposure to negative roll yield, making the index more representative of underlying price movements.”

Lastly, there are a variety of licensed investment vehicles providing exposure to these indices, ranging from active and passively managed mutual funds, exchange-trade funds, and exchange-traded notes. The key differences are active fund management that can come with higher expense ratios, versus lower cost passive index exposure. For example, Barclays iPATH’s exchange-traded notes that track the DJ-AIG Index returned 21 percent over the past year, pretty much reflecting the performance of the benchmark. PIMCO’s actively managed version of the DJ-AIG Index [Commodity Real Return Strategy Fund] was up by more than 30 percent over the same time.

While the PIMCO’s institutional class [$5 million minimum] and the Barclay ETN have relatively low annual expenses of around 75 basis points, the retail version of the former has a 5.5 percent front load and annual expenses of 1.24 percent.

So far PIMCO has earned its fee not only through superior collateral profits but via alpha that manager Worah generated by tweaking the index. He maintains the Index’s broad sector weightings [e.g., energy and precious metals], but he is able to vary his subsector exposure [e.g., natural gas and gold], based on which specific commodities he thinks will generate the greatest near-term gains.

Despite the clear differences among indices and funds, Daniel Nash, head of Morgan Stanley’s Commodity Index Trading Group, believes they can all provide a valuable hedge for most portfolios. “When commodities surge,” explains Nash, “index exposure can counteract the negative weight rising prices can have on stock and bond markets.” Moreover, he adds, the growing diversity of individual commodity ETFs is now enabling investors to target specific energy, metals, and agricultural products–short as well as long.

Source: Deutsche Bank and Bloomberg

Source: Deutsche Bank and Bloomberg