COMMODITY INDICES
Rather than investing in third generation indices, pension funds and other investors wanting exposure to commodities but disappointed with returns on index products should consider a fully active approach – either a long-only discretionary fund or a long-short hedge fund. There is also a suspicion that dynamic indices
are a marketing ploy designed to appeal to pension funds and others that have no mandate or appetite for investing in hedge funds and want the comfort of an index “wrapper” for compliance purposes or to make themselves feel safer. The third generation of indices promises not
only a more sophisticated roll procedure but also adjustment of weights to minimise contango drag, maximise backwardation and boost exposure to those commodities with the best spot potential. Third generation indices take two basic
approaches to re-weighting. One group of algorithmic products has tried to keep faith with the indexing philosophy by making re-weighting automatic, based on objective factors such as recent price performance or supply-demand balances. The best known example is the SummerHaven Dynamic Commodity Index, which selects the seven commodities with greatest backwardation and the seven commodities with the greatest price momentum from a universe of 27.
Front-Running Bubbles Index managers and operators insist they have
‘Chinese Walls’ in place and other safeguards to prevent investors from being front-run by in-house traders and associates. In reality, it will be easy for operators, their associates and totally independent third-parties to front-run the indices. In fact, it will be hard not to and would require them to act irrationally. Index behaviour will be, to some extent,
predictable ... which means the rest of the market will be positioned to exploit it. This is exactly what happened when the market started to game the roll period for the Goldman Sachs Commodity Index back in 2005-2009. The need to avoid predictability is precisely why hedge funds go to great lengths to conceal their strategies. Third generation indices based on algorithms
Dynamic indices will add to volatility and momentum ... creating the conditions for an explosive price movement
The second group is purely discretionary and
bases the re-weighting on the subjective view of an outside hedge fund or the recommendations of an internal research team. Credit Suisse was an early entrant with an index
weighted according to the views of Glencore. Goldman Sachs recently announced the launch of a dynamic index based on the views of Clive Capital, the largest commodity hedge fund. Other banks have launched products based on the price calls of their in-house analysts. Third-generation indices promise to resolve
the issue by rotating investors through a broad spectrum of commodities depending on which has the best outlook and most favourable contango or backwardation structure. But it is likely all third generation indices will
respond to the same signals – whether momentum and backwardation or current/expected supply- demand-inventory balances. They will all swarm into the same commodities at the same time in huge volumes, moving the market against themselves and quickly competing away the very returns that drew them in the first place.
are clearly predictable. Even for indices with discretionary allocations it will be possible to work out their allocations from published bank research or conversations with the hedge funds they are tracking. Dynamic indices will add to volatility and momentum. Once a market has started to tighten or a tracked hedge fund turns bullish, it will draw in the dynamic indices, creating the conditions for an explosive price movement. Since everyone knows this, the
correct strategy for all market participants will be to follow and anticipate the herd, trying to predict which commodities
the dynamic indices will be buying and selling. These are precisely the conditions in which bubbles and crashes will occur. The smart money will try to get in ahead of the indices, ride the momentum and then exit before the dynamic indices get a sell-signal and begin to liquidate. Investors frustrated by the lack of returns from
a passive (enhanced) investment in commodities will not find succour in active indices. If they want commodity exposure, there is no substitute for a proper active strategy – including its lack of predictability and ability to find new trades and niche markets first before the herd. •
John Kemp, Reuters market analyst.
He is a regular contributor to Commodities Now and Conmmodities Now online.
The views expressed here are his own.
www.reuters.com
Footnotes 1. Facts and Fantasies about Commodity Futures: Gary Gorton, The Wharton School, University of Pennsylvania and National Bureau of Economic Research & K. Geert Rouwenhorst School of Management, Yale University June 2004.
September 2011 55
Page 1 |
Page 2 |
Page 3 |
Page 4 |
Page 5 |
Page 6 |
Page 7 |
Page 8 |
Page 9 |
Page 10 |
Page 11 |
Page 12 |
Page 13 |
Page 14 |
Page 15 |
Page 16 |
Page 17 |
Page 18 |
Page 19 |
Page 20 |
Page 21 |
Page 22 |
Page 23 |
Page 24 |
Page 25 |
Page 26 |
Page 27 |
Page 28 |
Page 29 |
Page 30 |
Page 31 |
Page 32 |
Page 33 |
Page 34 |
Page 35 |
Page 36 |
Page 37 |
Page 38 |
Page 39 |
Page 40 |
Page 41 |
Page 42 |
Page 43 |
Page 44 |
Page 45 |
Page 46 |
Page 47 |
Page 48 |
Page 49 |
Page 50 |
Page 51 |
Page 52 |
Page 53 |
Page 54 |
Page 55 |
Page 56 |
Page 57 |
Page 58 |
Page 59 |
Page 60 |
Page 61 |
Page 62 |
Page 63 |
Page 64 |
Page 65 |
Page 66 |
Page 67 |
Page 68 |
Page 69 |
Page 70 |
Page 71 |
Page 72 |
Page 73 |
Page 74 |
Page 75 |
Page 76 |
Page 77 |
Page 78 |
Page 79 |
Page 80 |
Page 81 |
Page 82 |
Page 83 |
Page 84 |
Page 85 |
Page 86 |
Page 87 |
Page 88 |
Page 89 |
Page 90 |
Page 91 |
Page 92 |
Page 93 |
Page 94 |
Page 95 |
Page 96