Look to the future for commodity benefits

I have rather a love-hate relationship with commodities. I won’t bore you – yet again – with my profound scepticism about commodity “super cycles” but I will remind you that those who lampoon commodities do so at their peril.

Newsweek’s provocative recent article suggesting that cheap oil is “forever” and “if it’s in the ground,
it can only go down” is an example. True, most commodities have been falling in value over the long term but there’s that tricky word “most”. Some commodities (and I’d suggest including oil) haven’t been falling in price inexorably. Also, there’s huge variability over different decades and it depends on whether you’re talking spot prices or futures prices.

So, I believe the only way to capture the potential benefits of investing in commodity markets is to track a diversified futures-
based index. My justification for this is an oft-cited paper by a couple of US academics called Gorton and Rouwenhorst, that looked at returns from commodities over the 45 years to 2005.
It concluded that “the average annualised return to a collateralised investment in commodity futures has been comparable to the return on the S&P 500 . . . [and] outperformed corporate bonds”.

These equity-like returns had been achieved with higher volatility, the authors conceded, and decade-long returns varied greatly. But, crucially, they discovered that “over all horizons – except monthly – the equally-weighted commodity futures total return is negatively correlated with the return on the S&P 500 and long-term bonds . . . these findings suggest that commodity futures are effective in diversifying equity and bond portfolios”.

Gorton and Rouwenhorst also investigated what provided this diversification – and suggested two factors. “First, commodity futures perform better in periods of unexpected inflation, when stock and bond returns generally disappoint. Second, commodity futures diversify the cyclical variation in stock and bond returns”.

So, I believe the benefits
of commodities as an asset class are clear until another bunch of academics comes along and tells me otherwise. I’d even go so far as to say that all adventurous investors should have some exposure, no matter how small. The tricky bit comes with actually buying that exposure.

You could track a diversified commodity index using an exchange traded fund (ETF) or exchange traded commodity (ETC). But these are hugely diversified and simply reflect the aggregate value of outstanding futures contracts. That’s fine if you believe these markets are perfectly efficient – but
I don’t. Commodity markets are where professional insiders know how to work their magic – the proof is in the returns from commodity trading adviser (CTA) hedge funds that spend their time playing the technical factors in different niche markets.

Alternatively, you could buy some of the commodity unit and investment trusts run by the likes of Merrill Lynch. But these tend to invest in specific resource company shares. Resource shares generally move in the same overall direction as their underlying commodity markets. However, they’re also closely linked to mainstream equities, which means you’re not gaining diversification.

I reckon you’re much better off trying to buy the actual commodities, but with active management – you need market professionals who can play the trends and look at the fundamentals and take a decision to ignore some resources and go long/short on others. That word “short” is important – high volatility suggests there’s an awful lot of money to be made by betting against some prices. A few specialist funds are trying to do this. I’ve written before about a small US exchange traded note (ETN) from the Elements stable that tracks the S&P Commodities Trend Indicator (CTI), which looks at various technical (momentum)-based indicators to work out how to go long or short on specific commodities.

Now, another fund using a similar strategy is about to find its way to the London market. It’s called the Comac fund and it’s due to be floated in May or June by the structured products boffins at BNP Paribas. It will track something called BNP Paribas Long Short Total Return Index – and, slightly oddly, also use a discretionary active fund management approach.

Here’s how it works. Swiss-based Tiberius Group sits down every week with its traders and analysts and looks at 25 different commodity futures markets to work out which ones to go long or short on. That analysis is based on fundamental factors such as the shape of the forward curve, as well as “supply and demand indicators”, climate, geopolitics, momentum and chart interpretation.

BNP Paribas has now constructed an index around these weekly calls. It has even run the inevitable back-test to “prove” the viability of the concept – although it only goes back to 2005 so it doesn’t really amount to much in my eyes.

Even so, I particularly like two features of this new fund. First, it will operate as an open, accountable and fairly transparent investment trust allowing real-time pricing and fees that are not extortionate at 1.55 per cent a year (plus performance fee). Second, it will use an active fund manager in a systematic and defined fashion.

Whether it’s all a bit too clever, I can’t say – I suspect the numbers will speak for themselves over the next year or two as markets stay highly volatile and in a downwards trending pattern.

adventurous@ft.com