It’s time to wake up and smell the coffee

I’m not a coffee drinker but even I couldn’t help notice that back in February, coffee prices suddenly shot up, putting Starbucks in a bit of hot water.

Against this backdrop, I also noticed the launch of some coffee funds by specialist hedge outfit Eiger Trading Advisors. These four funds – two trackers (long and short), one managed alpha fund, plus a green/sharia-compliant fund – aren’t likely to feature in many readers’ portfolios as the minimum investment is $1m. But I think the launches are notable for a number of reasons.

First, coffee is a specialist commodity that lives up to its reputation as a non-correlated asset. In 2005, a couple of US academics released a paper called Facts and Fantasies about Commodity Futures 2005 (Gorton and Rouwenhorst) that spelled out why commodities as an asset class could be so useful. The key observation was the low correlation of commodities with equities.

A subsequent study by researchers at Ibbotson Associates for Pimco, the US bond firm, backed up this point, suggesting that commodities should have some benefit for most portfolios. It even went so far as to put an estimate of the benefit – 133 basis points.

Sadly, as we’ve recently discovered, many commodities have been anything but negatively correlated to equities, as investors have sold those with cyclical vulnerability. Oil has plummeted in value, closely followed by coal and just about anything industrial. Coffee, however, has remained resolutely independent, rising and falling in line with factors such as the weather, or whether or not futures traders have got their sums wrong.

Which brings me to the second reason why I think we should take some interest in the Eiger funds – the two new index funds are not based on futures prices but the spot price (although the tracking itself is done using derivatives and futures).

This is important in my book because I sense there’s something rotten in the land of commodities and it’s called the futures market.

I’ve received countless e-mails from readers who have a hunch about where commodities prices are going in the next few weeks, months or years. These e-mails usually proceed to mention one of the ETF Securities commodity trackers (called ETCs) that they intend to buy or sell.

The problem that I see is that the ETF Securities funds (along with the smaller number of more general commodity trackers from Lyxor) track the futures markets.

There isn’t anything wrong with this as such (in fact it makes the tracking easier), but investors should be aware that there isn’t a straightforward overlay between futures and spot markets and vice versa. Futures markets have a curious internal dynamic based around the move between contango (when futures prices rise above spot prices) and backwardation (when futures prices fall lower than spot prices). The Eiger family of funds, by contrast, deliberately only track the spot price.

“We’re trying to avoid a lot of the inefficiencies of the futures markets,” says Eldred Buck, the fund manager.

To understand what Buck means, I suggest logging on to FT Alphaville or the excellent US investment blogging website www.seekingalpha.com. Look up the articles “A Self-propelled Pyramid” (FT Alphaville) and “Death by a Thousand Contangos” (SeekingAlpha), which brilliantly remind private investors of the risks of commodity markets – and especially futures markets for oil.

Some parts of the problem are well known – the huge US oil tracker fund USO is now so big that when it rolls over its investment in the underlying futures contracts it causes the main market to move violently.

Both articles quote Stephen Schork of the Schork Report on recent moves in USO. “The USO held sway over the market, i.e. these funds (USO, S&P GSCI et al) are artificially skewing the front of the Nymex curve; putting downward pressure as they sell a massive percentage of open interest in the spot over the course of a few sessions”.

Also, private investors have to factor in the movement back and forth between contango and backwardation – as well as consider the impact of any move in Treasury Bill yields.

Add it all up and you begin to understand why some academics maintain that between one and two thirds of all long-term returns from futures-based indices come from these complex factors. In the US, for instance, Van Eck Global Research estimates that, in the 1980s, the cash yield from Treasury Bills contributed annualised returns of more than 9 per cent while spot prices returned -1.37 per cent.

And for coffee itself – what are the prospects? Well, it has rallied recently and it will probably fall back again, but the point is that spot prices move relatively independently of equities and that diversification has real value. The growing consumerism in the developing world that’s pushing up demand for meat-based diets must also spill over into increased coffee consumption. And even if it doesn’t in the short term, my experience of recessions so far is that they result in people spending a lot more time in coffee shops talking about what they’re going to do next!