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ALTERNATIVE INVESTMENTS


A primer on commodity alpha


Investors often approach their commodity allocation as a single allocation, but the global commodity index and products Asia team at Bank of America Merrill Lynch have a different view.


T


hey say a commodity asset allocation should be approached as two conceptually distinct portfolios: a primary portfolio that aims to give investors an optimal allocation to the


asset class (“commodity beta”), and a secondary portfolio that aims to extract absolute returns more or less independently of market conditions (“commodity alpha”). The clear separation between commodity beta


and commodity alpha helps investors focus on what is most important to them. For many investors, the bulk of their commodity exposure aims at giving access to commodities as an asset class, that is, to commodity beta. A long-only or long-biased active manager who does not wish to have significant drawdowns relative to the benchmark has to have the bulk of her allocation in a vehicle tracking a benchmark index. This, they say, is inefficient, and investors have a lot to gain from making sure that their beta commodity allocation is done through a well-designed and cost-efficient vehicle.


Alpha is different from active management After getting access to a well-designed and cost- efficient beta instrument, investors should focus their attention on commodity alpha. However, some investors mistakenly associate commodity alpha with active management. Commodity alpha is the difference between returns


in a commodity investment and the returns of some beta benchmark. In other words, commodity alpha is any commodity return that cannot be obtained by simply getting exposure to a benchmark. Of course, active management is one way of obtaining alpha. But market-neutral returns can also be obtained through systematic passive exposure in many different ways.


Where does commodity alpha come from? Commodity alpha is just another type of risk premium. Structural commodity alpha is not a source of risk-free returns and is not the result of arbitrage; it is just a by-product of risk premium. Investors can obtain systematic market-neutral returns in commodities by taking on risks that other market participants are unwilling to take. In general, the risks that can be exploited to generate systematic


commodity alpha fall into two categories: price risk and liquidity risk. Strategies that provide price insurance and liquidity to market participants on a systematic basis are rewarded with positive returns. Of course, these strategies are not riskless, but they can be constructed in a way that they become more or less independent of the factors that affect commodity price levels. As a result, their returns are more or less uncorrelated to market returns. Even though these strategies are not independent of market fundamentals, they cannot be replicated by simply getting exposure to a broad-based commodity market benchmark. Hence they constitute pure commodity alpha. Three rules-based investment strategies (as distinct from active or managed strategies) can be followed under commodity alpha.


CHART 1 Rolling Mechanism for Futures Contracts


62 60 58 56 54 52 50 48


$/bbl


In backwardation, rolling returns are positive, as front-month exceed second-month contract prices.


SELL FUTURE BUY FUTURE


In contango, rolling returns are negative, as front-month are below second-month contract prices.


Front month


2 3 4 5 6 7 8 9


month month month month month month month month Source: BofA Merrill Lynch Commodity Research


68 FAMILY OFFICE: ASIA TOMORROW Spot and Roll Returns of Various Rolling Methodologies Source: Bloomberg, BofA Merrill Lynch


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