Commodity Indices: Struggling Against the Tide
Investors frustrated by the lack of returns from a passive or enhanced investments in commodities will not find succor in active indices. If they want commodity exposure, there is no substitute for a proper active strategy, argues Reuters market analyst John Kemp.
EQUITY INVESTORS HAVE long been divided over the comparative merits of active management versus passive approaches to investment – whether portfolio managers can add value beyond the returns on a broad-based equity index in a sustainable way that is not swallowed up by their fees. “Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds,” wrote Professor Burton Malkiel, whose bestselling Random Walk Down Wall Street has sold over a million copies in multiple editions since 1973. It remains the most famous exposition of the merits of the index-based approach to investing. Malkiel’s index-based approach is not without
critics and an entire active management industry is based on the idea it is possible to add value beyond fees through skillful stockpicking and market timing. But his theories does capture an important point.
Premiums For Shouldering Risk ... Equity investors should expect a positive return
from simply holding a portfolio of shares because they capture an equity risk premium, either in the form of dividends thrown off by companies or appreciation in the stock price. Malkiel doubted whether an active manager could consistently and predictably outperform the index, hence his advice to buy and hold a broad-based index. Of course, some managers do
outperform the index, occasionally for years a time, but it is almost impossible to know which ones will do so in advance. So Malkiel’s advice boiled down to the idea of ‘buy and hold’ a broad index and pocket long-term returns from the equity risk premium. The same terminology of active management
reason why investors should expect a positive real return from buying and holding a commodity index. In particular, they do not capture an equity risk premium and evidence they can capture a premium for shouldering commodity price risk on behalf of producers and consumers is scant.
... Vanish in Commodities After 2004 Between July 1959 and December 2004: “an
investor in our index of collateralised (equal- weighted) commodity futures would have earned an excess return over T-bills of about 5% per annum ... (T)his commodity futures risk premium has been equal in size to the historical risk premium of stocks (the equity premium) and has exceeded the risk premium of bonds,” wrote Gary Gorton and Geert Rouwenhorst in 2004. “This evidence of a positive risk premium to a long
position in commodity futures is consistent with Keynes’ theory of normal backwardation,” they argued in their famous paper Facts and Fantasies about Commodity Futures1
that helped kick-off the
commodity indexing boom. But if there was once a futures risk premium that investors could capture by taking on price risk commodity producers were anxious to shed, it seems to have disappeared shortly after the paper was published as investors moved en masse into the new asset class.
The same terminology of active management
versus passive index-based investing has been appropriated by sellers of commodity products
Figure 1 overleaf shows the various returns
versus passive index-based investing has been appropriated by sellers of commodity products – with the implication that investors can reap some sort of long-term return just for buying and holding a broad basket of commodity futures and options. But commodity futures are not like equities at all,
and commodity indices have nothing in common with equity indices except the name. There is no
(spot, roll, T-bill) available to investors from holding a fully collateralised position in a broad- basket of commodity futures since 1988. We have used the Goldman Sachs Reduced Energy Index because its reduced weightings for crude are more representative of the indexing sector as a whole and it mitigates the worst excesses of the well- known contango problem in WTI futures. But the conclusions remain true using other indices. Total returns were mostly positive, though rather unspectacular between 1991 and 2004. In addition to gains from appreciating spot prices investors
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