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Portfolio > Alternative Investments > Commodities

More Than Meets The Eye

By Bob Keane

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Appearances can be deceiving, and experts can look at the same data and draw different conclusions. Take Oppenheimer’s Real Asset Fund. Its top holdings appear to be cash, government agency securities, and corporate bonds. S&P says it’s an equity fund with a four-star rating. Morningstar categorizes it as a specialty/natural resources fund and gives it five stars.

However, there’s no dispute that the fund has performed quite well since its inception in 1997 and delivered returns that surpass the S&P 500 and compare highly favorably with its benchmark, the Goldman Sachs Commodity Index. For the most recent fiscal year, ended Aug. 31, 2003, the Fund’s Class A shares returned 23.08%, while the Goldman Sachs index returned 21.95%.

According to manager Kevin Baum, who’s probably in the best position to know, the confusion is understandable. But he stresses that QRAAX is a commodity fund that strives to stay 100% invested and provide investors with portfolio diversification.

The fund has another manager besides you. How would you describe your roles? When you invest $100 in this fund, you get $100 of commodity exposure. That is the exposure I’m managing, but we’re able to provide that exposure in a way that still allows us to hold some of our cash and invest it in a basket of short-term, essentially zero-interest-rate-risk, fixed-income securities. That piece of the portfolio is managed by Angelo Manioudakis and his team.

What’s the investment philosophy behind this fund? It’s pretty simple. First and foremost, we want to adhere to product integrity, meaning we try to stay fully invested, giving one dollar of commodity exposure for every dollar invested. We’re not trying to time the markets or make directional calls on whether commodities are in or out of favor.

We do believe there are certain inefficiencies in these markets, which afford us the opportunity to implement some low-risk, low-tracking-error active management strategies that are simply meant to earn incremental returns for the investor.

How do you decide which particular instruments you’re going to use? Going back to product integrity, that includes adhering to our performance benchmark, which is the Goldman Sachs Commodity Index. The Goldman Index is a basket of 24 commodities, which are weighted based on each commodity’s importance in the global economy. The formula takes world production quantities of these 24 commodities and multiplies those quantities by their price to get a value. So what we’re doing, within the index and subsequently within the Real Asset Fund, is allocating our dollars to the commodities that play the largest role in the economy, and then subsequently have the largest impact on financial assets.

That’s really the name of the game–to provide diversification against the stocks and bonds in an investor’s portfolio. If you’re looking for diversification or some protection for your stocks and bonds, you want larger allocations to the commodities that, as they rise in value, have the most detrimental impact on the stock or bond market. So you’ll find a large energy weighting, because energy is the commodity that most directly impacts the economy. That’s our starting point for how we’re going to allocate our commodity exposure.

Around the edges, we use several active management strategies that attempt to very modestly shift weight between commodities, oftentimes within sectors. We’re not taking large bets, but relative-value strategies, where we may slightly increase exposure to one energy commodity while we decrease another.

That’s our commodity exposure, which is collateralized with the short-term, high-quality fixed-income securities managed by Angelo Manioudakis’s team. What they’re looking to purchase is a highly diversified basket of governments, government agencies, a few asset-backed securities, and some high-quality, short-term corporate bonds.

You mentioned your active management strategies. What do you do, exactly? The best way to explain it is with an example. We’re looking at relative value opportunities in, say, the energy sector between petroleum and natural gas. Over the last couple of winters we’ve seen sharp spikes in natural gas prices. Not all consumers or users of heating oil or petroleum products and natural gas can switch between their fuel sources, but some utilities and industrial users do have the ability to switch to the cheapest source of fuel. When natural gas prices spike, the BTU equivalent price of competing fuels, such as residual fuel or heating oil, becomes attractive to those users. So we’ll see demand increase for heating oil and we’ll see demand decrease for natural gas as those users switch. What we do is look at some of those relationships and when we see a dislocation, we’ll widely reduce our exposure, say by 2% to natural gas, and increase by 2% our exposure to heating oil. We’ll hold those positions until the prices of those two commodities move back into something closer to equilibrium. That doesn’t change the investor’s total allocation or exposure to energy, it just modestly shifts where that exposure is coming from. That’s the kind of strategy we’re trying to use to maintain our totally invested position.

How often are the holdings adjusted? If you look at our top 20 holdings, you’ll notice quite a few of those holdings are essentially bonds. So how is this a commodity fund if the largest holdings are fixed-income securities?

Let me use an analogy. If you want to buy the S&P 500, an investor could buy 500 individual stocks that would require cash up front. Alternatively, you could go long with an S&P 500 futures contract that gives you long exposure to the S&P 500, but requires no up-front cash. With that cash you can go out and buy three-month Treasury bills, or you can buy government agencies, and so forth. Those two alternatives are essentially the same investment, because in both cases you’re going to earn the return of the Standard & Poor’s 500.

The Real Asset Fund follows the latter strategy. The way we gain our commodity exposure is by going out to investment banks, to Wall Street dealers, to commodity producers, and purchasing from them the returns of the Goldman Sachs Commodity Index. We do that by buying a one-year financial instrument where the monies we pay them are returned to us in one year, plus or minus the return of the Goldman Sachs Commodity Index. We are able to do that while only employing a portion of our cash, yet still getting 100% exposure to the commodity market.

That’s the reason that you find that some of our largest holdings–in fact the overwhelming majority of what appears to be our assets–are allocated to this basket of short-term, high-quality fixed income securities. Make no mistake about it, this is first and foremost a commodity product.

But when you look at the research, it still seems there’s a lot of cash in there. That’s because we still have our cash and it’s Angelo’s decision as to whether it’s more attractive to simply do an overnight repurchase agreement with that cash, essentially a one-day fixed income instrument, or to buy a six-month Treasury bill, or a one-year government agency security. The repurchase agreement is a large portion of the fund, but what you’re earning is short-term overnight interest on that security. The percentage of our repurchase agreements will fluctuate from time to time as [Manioudakis] finds more attractive alternatives in the market. The [fund's] large cash position shouldn’t be mistaken for a manager who is bearish and is not fully invested in the core assets.

The fund’s had years when there’s been a huge negative return followed by several years of positive returns. Why does that happen? You could look at the last three or five years and say, “Wow, commodities have been an outstanding investment–look at these strong returns.” But if you look at the longer history, you’ll find there’s been a very consistent pattern of negative correlation between commodities and stocks or bonds.

Commodities are not immune to negative returns, but the return pattern is different than for stocks or bonds. When you add commodities to an investment portfolio, you’re getting a much more efficient portfolio, which maintains its return profile but with lower volatility.

A lot of people say we’re coming to the tail end of a positive cycle for bonds. What impact would that have on your fund? There are two important things we need to address to answer that question. One is that the bonds we hold as the collateral in this portfolio are very short-term in nature: The interest rate risk of the portfolio looks very similar to the interest rate risk of a three-month Treasury bill. That’s why I made the comment earlier that this is, first and foremost, a commodity fund. We don’t want the investor holding a lot of interest-rate risk.

When we look at fixed-income securities, we’re looking for short-maturity instruments. For the ones that are not short maturity, we go into the futures market and hedge out that interest rate risk. A rising interest rate should not be detrimental.

When we look at commodities and the historical performance of commodities relative to bonds, again what we find is this negative correlation between these assets. There are business cycle reasons for this. Quite simply, when economies are growing above trend, as they are now, often we’ll see interest rates begin to rise. When economies are growing, the demand for commodities is growing.

Will rising interest rates have any effect on your commodity investments? Rising interest rates have limited effects on our returns. In some ways they actually contribute to our returns because these short-term, fixed-income securities we’re buying are ultimately being replaced with higher-interest-earning fixed-income securities. The more important issue is the bigger business cycle environment we’re operating in. If interest rates are just rising gradually, that’s a function of a growing economy and is likely to [create] an environment where commodities are going to be performing positively.

Where do you see the Real Asset fund fitting into the typical investor’s portfolio? We look at this as a 5% to 15% maximum allocation to an investor’s portfolio since it’s meant to complement the stocks and bonds that they hold. It certainly should not be looked at as a stand-alone investment. The long-term returns of commodities have been strong. In fact, over the last 35 years, commodities have generated returns equal to or better than the S&P 500. So [the fund] is a strong long-term investment.

Why should an investor put their money into this fund as opposed to a similar investment? If by similar investment you mean a natural resource equity fund, there are some very important differences between these two. With a natural resources equity fund, you’re buying the equities of companies in the commodity-producing business. When we look at the historical return profile of those equities, they are most directly impacted by changes in the broader equity market, not necessarily changes in the underlying commodity prices.

What do you see happening in the commodity market in the next six to 12 months? We do not spend a lot of time trying to make directional predictions or forecasts on the individual commodity markets. Our active management strategies are built more around relative value opportunities between commodities within sectors. But the variables, of course, are always supply, demand, and inventory. We see that demand is growing. Economies around the world are growing. Turning to supply, we are seeing modest increases in the supplies for certain commodities, but supply responses do not occur overnight. They take, in most cases, several years to play out. So we’re probably a couple of years away from seeing a material supply response in many of these markets. The third variable is inventories. Several commodities markets have seen some rise in inventory levels, but across the board, we’re still looking at below-normal, below-trend inventories for most commodities.

I think when you add those three components together, it’s not surprising that we’ve seen a bull market in commodities. Commodity prices have been appreciating because the fundamental environment is good for commodities.

Staff Editor Robert F. Keane can be reached at [email protected].

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