From the January 2011 issue of Investment Advisor • Subscribe!

January 1, 2011

Investing in Commodities and Futures

Can a commodities index compete with actively managed accounts?

Some of the smartest investors realized years ago that commodities and financial futures belonged in their portfolios. Between practitioners and academic researchers, common agreement was reached that commodities and futures investing (CFI) does lower volatility (risk), increase returns and is uncorrelated to the typical asset classes of stocks and bonds. Everyone else became a believer after 2008, when CFI was the only sector left standing. Now that everyone is on board, the debate has shifted to passive versus active management. Can an index of commodities or financial futures deliver the same performance as actively managed accounts? Our research says active outperforms passive by a wide margin, and after all costs are accounted for, too.

CFI, a commonly-used designation, is a bit of a head-scratcher because it encompasses much more than it literally says. “Commodities investing” refers narrowly to assets which come out of the earth and are in physical form, whether an agricultural product, a metal, oil, etc. The “futures investing” part technically only describes a single and specific trading vehicle, a futures contract. While there are futures contracts on many different underlying assets and markets including currencies, bonds/interest rates, and commodities themselves, CFI, in practice, includes many more trading vehicles. For example, these others may include forwards, options, swaps, commodity-related equities and even cash and carry in the physical commodities. In fact, they may be the most diversified of all investment alternatives. Out of over 100 asset classes and markets commonly traded, approximately 65 have enough volume to be considered active and deep and are therefore used the most.

The challenge is how best to achieve CFI exposure and its positive benefits, while minimizing any detriments. Yet, we have all learned, heard and seen the risks, but know little about “how to get the benefits.” What follows could be fairly labeled an exposé of some of the myths, as well as a summarized comparison of alternatives.

Adding CFI Exposure
There are many ways to accomplish CFI exposure, but the first decision is how much money to allocate. In one study, Ibbotson, a notable research firm, calculated that 25% of a diversified portfolio was the optimal historical allocation. However, most investment advisors would say that a better target would be 5% to 15%, depending on the knowledge, time horizon and personal risk tolerance of the investor.

Second, where and with whom should I put my money? And, should I go passive, active or both? A passive or static approach may be rules-based and implemented mechanistically without subjective discretionary judgments made by the manager. Usually, trading is infrequent; most often, the strategy is long (seeking price increases). Some passive funds invest using an index or basket of “stuff,” while waiting for the desired price movement. Active means relying on the manager’s judgment to select which markets, allocation amounts and time period.

Active investing in CFI through your friendly broker means using your own or their advice. However, verifying the broker’s prowess in offering advice may be more than challenging, so that you may be forced to rely on your own expertise. Managed accounts at brokerage firms can work, but are not for the faint of heart because of the margin issues, which expose the investor to the possibility of losing more than the starting capital.

ETFs in CFI
The big sellers of financial services to individual investors have sought simple, broad-based and widely available investment alternatives to tap as many investors as possible for passive investing. The most popular—intensely marketed and providing attractive revenues to the seller—have been exchange-traded funds, the ubiquitous ETFs offered on many different markets, e.g., the U.S. Oil Fund, U.S. Natural Gas Fund. Typically, an ETF buys futures contracts in its designated market hoping for price appreciation.

The challenge has been that many of these ETFs were launched during a time when many futures contracts traded more expensively in the near-term months of expiration and less so as time lengthened (called backwardation). This phenomenon meant that an ETF could passively invest in the desired futures contract and, as it neared expiration, roll the investment forward to the next time period, earning small profits even without upward price movements in the underlying asset or market. Unfortunately, this price pattern can and did reverse. Longer-term futures contracts became more expensive than the shorter-term contracts (called “contango” by traders). When upward price movements were insufficient to offset the negative price spread between the contract being sold and the one being bought, steady losses were experienced. Worse yet, traders pounced on these “known” rolls seeking to capitalize on the ETF’s trading patterns. In order to capitalize on the price movements from these new entrants, Wall Street firms have used storage facilities in unprecedented amounts to take physical delivery as another way to trade against them. Whether due to the trading from others or a flawed product design, many of these ETFs have not accurately tracked the price movements of their underlying asset and market classes.

CFI is growing quickly, stimulating the creative juices of Wall Street and, as a result, its offerings will develop at a rapid pace. Move over Baskin and Robbins, the ETF flavors are many, growing, and evolving in their structures. There are spot funds investing directly in the asset, plus short (inverse), leveraged, equity-based, etc. To combat their flaws, there are new roll strategies, long-dated futures contracts, and more on the drawing boards. The biggest, double digit billions, are the spot or directly investing ETFs in gold and silver. This approach solves problems with tracking error and costs of the future contract rolls, but does incur costs of storage.

ETF creators are now experimenting on the public with formula-driven semi-active strategies. These approaches, dreamed up by professors of finance and mathematics from major universities, may work, but who knows? As one professor recently said when queried about his poor performing approach, “We need more research!” Hence, we believe these newest ETFs are best avoided altogether until they prove themselves.

Exchange-traded notes (ETNs) have sought to improve on ETFs. A financial institution directly guarantees the price tracking instead of using a futures contract to capture price movements from the underlying asset or market. However, since the financial meltdown of 2008, many market participants fear that these guarantees will not be collectible in the event of another crisis. As a result, the ETN marketplace has not yet displaced the flawed ETF, notwithstanding the improved tracking, but should grow as 2008 fades from memory.

Active Vs. Passive
Active CFI investors receive the key benefits of passive, with low or zero correlation to equities and bonds, as well as lowered portfolio volatility when included in a traditional stock portfolio. In addition, active CFI historically offers more than passive:

1. Higher returns
2. Lower correlation to stocks
3. Forty-four percent lower volatility
4. Lower maximum drawdowns
5. Positive returns during stock loss months

The index of active commodity and futures managers has outperformed the passive index. However, this comparison is far from perfect:

1. Is each market equally weighted between the indices? No.
2. Is there potential “survivor bias” in the Barclay manager index? Yes.
3. Does the selected time period matter? Yes.
4. Have individual active managers and funds of funds significantly outperformed their index? Yes, and over even longer periods of time.

The answers to questions 1, 2 and 3 are trumped by the compelling yes of 4, and we believe would stay trumped even with perfect information, albeit the gap might narrow to be fair. Alas, perfect information is never available at an affordable price or in a timely fashion. Managing money or businesses requires the scary process of evaluating, digesting and acting upon imperfect information.

Our comparisons are based on asset indices and an average of “active” managers. If one were to compare a passive approach to an active one using some of the best and the brightest managers, the results are startlingly compelling, whether for a single manager or a fund of funds. Generally funds of funds have less volatility and, surprisingly in some cases, better long-term returns than many of the best single managers.

With most ETFs still somewhat flawed, ETNs possibly insecure and the mutual fund executions new, untested and receiving renewed scrutiny from government regulators, active management is the best bet for the appropriate investors. Individually managed accounts and limited partnership interests win the race if analyzed deeply, ever so thoughtfully selected and invested in with moderate allocations, depending on the objectives of the particular portfolio.    

Alan C. Snyder is the managing general partner of Shinnecock Partners and its investment limited partnerships. Mr. Snyder is a graduate of Georgetown University and Harvard Business School, where he was a Baker Scholar.

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