COMMODITY INDICES
Figure 2: Components of Commodity Index Returns Goldman Sachs Reduced Energy Index
500 400 300 200 100 0 -100 -200 -300 -400
Percent of total return attributable to spot yield Percent of total return attributable to other components
Sources: Standard & Poor’s, Reuters, J. Kemp
The only sustainable returns come from employing superior skill, knowledge, information and leverage as part of an active management strategy
Indices Self-Defeating
Commodity indices generate three types of return: (a) Spot returns from the appreciation in spot prices;
(b) Roll returns from selling a maturing futures contract and replacing it by buying a cheaper longer-dated one; and,
(c) Collateral yields from the Treasury bonds or other securities held as collateral for the index position.
Index strategies have fallen prey to two problems:
(1) The sheer volume of money chasing the same strategy has forced many markets into contango (or smaller backwardations) cutting roll returns and in some cases turning them into roll costs; and,
(2) The extended period of ultra-low interest rates as a result of the financial crisis has slashed collateral yields.
Investors have become increasingly dependent on spot yields. But
prices do not appreciate indefinitely. Capturing spot yields requires investors to sell holdings after a period of price gains to book profits. But index products lock investors into long positions. So they make paper profits when the commodity goes up in price and then give them back when it falls afterwards.
Second generation indices attempted to cut roll costs and improve
yields by shifting investments along the curve where the contango was smaller. But that also limited the ability to participate in backwardations, (which tend to be smaller out there too). And they did not resolve the spot price problem of needing to sell out of commodities at or near the peak to lock in profits.
54 September 2011
inflation. Unlike their (notional back-tested) predecessors of the 1950s-1990s, commodity index investors should not expect to receive long-term positive returns after inflation. If there is no longer any commodity futures risk premium to be captured from holding a long position in a broad basket of commodity futures it does not matter much whether investors employ a purely passive index, an enhanced one or a dynamic one. The only sustainable returns come from employing superior skill, knowledge, information and leverage as part of an active management strategy. This is what some of the new generation of dynamic index
strategies aim to do. But there is nothing automatic or index-like about active strategies. They are analogous to actively managed mutual funds rather than broad-based equity.
Dynamic Commodity Indices The third generation of so-called ‘dynamic’
or ‘actively managed’ commodity indices being marketed at the moment are unlikely to improve returns for investors and come with special risks of their own. The clever packaging implies they
will benefit from the best of both worlds – the predictability, transparency and comparatively low risk of an index coupled with the superior returns of an actively managed commodity fund or hedge fund. In reality, investors risk getting the worst
of both. The concept of a dynamic index is a contradiction in terms. The more they behave like a hedge fund, the less they will resemble a traditional index product. Third generation indices are likely to
suffer all the problems that plagued the first and second generations without capturing the full advantages of discretionary management of a hedge fund. The real danger is that these indices will be uniquely vulnerable to front-running and to becoming ensnared in bubbles and crowded trades. Instead of being first in and first out, riding market momentum, investors in a dynamic index risk being last in and last out – market followers stranded ‘long and wrong’ at the top after true hedge funds have exploited their momentum and cashed out.
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