Commodity investors seek ways to beat correlation

Date: Thursday, July 14, 2011
Author: Claire Milhench, Reuters

Investors may increasingly look to market neutral and managed futures strategies for their commodity exposure if they want to avoid the higher positive correlations that commodities have shown with other asset classes since 2008.

Pension funds have steadily increased their exposure to commodities since 2005, in some cases allocating as much as 5 percent of their overall portfolio.

But as inflows have risen against a backdrop of government money printing programs, returns have become more correlated with those of other asset classes -- particularly equities.

Now, with commodities failing to deliver the kind of diversification that investors need, managed futures and market neutral fund managers are reporting increasing take up from pension funds seeking an uncorrelated commodity performance.

In this approach, instead of the pension fund investing in commodities as part of a broad strategic asset allocation, the commodity exposure forms part of a discretionary fund manager's tactical asset allocation.

"We have had some interest in us as a commodity manager but principally we are seeing interest in us as a systematic global tactical asset allocation (GTAA) manager," said Ted Frith, head of institutional sales at Aspect Capital, which has about $5 billion in its managed futures strategy.

"The increasing trend is to view managed futures managers as a means of tactically allocating risk."

Investors are embracing this tactical approach as commodities have failed to deliver uncorrelated returns.

Far from providing some protection when equity markets are tanking, commodities have tended to move in lock step with stocks since September 2008.

The S&P GSCI - a popular index for passive commodity investors - was down 7.94 percent in the volatile second quarter, as markets sold off across the board.

DISAPPOINTING DIVERSIFIER "The argument for investing in commodity futures is somewhat less compelling than I thought it was five years ago," said Robert Farago, head of asset allocation at Schroders Private Banking, highlighting the impact of negative roll yields.

In the last two years, despite a rebound in the economy and markets, high correlations have persisted, making Farago cautious. "Perhaps it's related to (quantitative easing), but whilst it's there, we don't see commodities as the diversifier they once were," he said.

Aspect's Frith argues that managed futures and market neutral strategies may offer investors an alternative. Aspect's Diversified Programme invests in a broad range of liquid commodity and financial markets including stock indices, bonds and rates, and currencies.

It is 100 percent systematic in its approach with position size driven by models that identify trending behavior. "We are comfortable being long or short, so we can make money equally in rising or falling markets and we don't have any view on how long trends will last," said Frith.

But the big draw for pension fund trustees is the variable correlation that managed futures have with equity markets.

Managed futures are both negatively correlated with equities when stock markets are falling, and positively correlated with equities when stock markets are rising, a win-win for investors.

"And it is the negative correlation which will help you in a crisis," said Frith. "If you put managed futures in a portfolio it often reduces the overall volatility of the portfolio, improves the returns and reduces drawdowns, and that's why pension funds are being attracted to it."

Market neutral strategies are also attracting interest as they tend to be less volatile and uncorrelated with benchmarks of general commodity market performance, according to research by Barclays Capital published in May.

Although target returns for market neutral strategies may be relatively modest, by offsetting long and short exposures on different parts of individual commodity price curves they can hold up well in turbulent markets.

The Equinox Commodity Strategy Fund, a market neutral fund launched at the end of last year, is a case in point. It came eighth in a table of over 100 commodity funds for the second quarter, up 1.96 percent when the average fund was down 5.11 percent according to Lipper data.

Ajay Dravid, a portfolio manager at Equinox, said because the fund is market neutral, performance is not dependent on the market direction of commodity prices.

It also seeks to increase exposure when volatility is low and reduce it when volatility is high.

"If you look at recent history it becomes clear that a long-term buy and hold allocation to commodities may not necessarily serve you well," said Dravid. "This fund gives you a steady return, volatility under 6 percent per annum and a correlation of close to zero with equities."

He suggested that because commodity futures suffer from sudden price spikes and reversals, managed futures or commodity trading advisers (CTAs) may be a better choice than passive long-only strategies, as they can go long and short.

However, Schroders' Farago questioned whether the managed futures/GTAA approach to commodity investment ticked all the pension fund investment boxes.

"What that misses is inflation protection. You may end up being short commodities at a time when inflation expectations are increasing, and concerns about inflation are pretty high up most people's agenda," he said.