Are commodities at risk of de-financialization?

Date: Thursday, May 31, 2012
Author: John Kemp, Reuters

Unless returns on commodity futures and options start to pick up soon, institutional investors may sour on the asset class and scale back or terminate their exposure to it, ending a decade-long trend that has seen increasing financial involvement in commodity derivatives.

The first five months of 2012 have brought more disappointment for pension funds and other investors with a long position in a diversified basket of commodity futures.

It has been a rough ride for investors across most asset classes, except ultra-safe havens like U.S. Treasuries and German bunds, as early optimism has given way to growing fears about the outlook, repeating the cycle of hope and despair evident in 2010 and 2011.

But the performance of commodity futures has again lagged behind equities. While the S&P 500 U.S. equity index is still showing gains of almost 7 percent for the year, after peaking up 13 percent in early April, the S&P Goldman Sachs Commodity Index and its various derivatives are down 5 percent, after peaking up about 10 percent in late February. Both indices are quoted on a total return basis.

SUPER-CYCLE EXHAUSTION

My colleague Javier Blas at the "Financial Times" has written an excellent article asking whether the so-called "super-cycle" has run its course ("A less-super commodities supercycle" May 29).

"The boom in demand that has propelled prices of raw materials from oil and copper to iron ore and bananas to record highs is showing signs of exhaustion," Blas writes.

"It makes more sense to think of the commodities super-cycle not so much as a looming bust but as less "super" and less "cyclical". Raw materials prices are likely to settle at a higher level than previously, with ups and downs tracking swings in economic activity."

"Long-only passive investors tracking popular commodities indices such as the S&P GSCI, who have simply ridden year-after-year price gains without worrying about the difference between, say, aluminum and cocoa, would be unlikely to make as much money," in a new era of trendless high prices, Blas explains.

RISK PREMIUMS EVAPORATE

But even before the super-cycle ran out of momentum, passive investors in commodity futures and options were struggling to make money. Returns on the GSCI and its derivatives have been lower than U.S. equities over almost any time horizon since 2000 (here).

Unlike an investment in equities, commodity futures do not provide a stream of dividends. Instead investors have been hit with the cost of storage. Passive index investors have been hit by the reduction in bond rates, which has hit the collateral yield on the safe financial instruments used to collateralize their holdings of commodity futures.

There is also evidence that some commodity markets have become overcrowded, with index investors competing away the risk premium and roll yields that existed before the asset class became fashionable in 2004.

For a time, the surging spot prices for a range of commodities, from crude and copper to iron and cotton, masked the deterioration in underlying performance of the indices. But as the super-cycle gives way to a period of plateauing prices, the problems with a passive long-only exposure are becoming more apparent.

PENSION FUND RESPONSES

Pension funds and other institutional investors, along with their professional advisers, are notoriously slow to respond to new investment trends, given the thoroughness with which they must assess the appropriateness and risk of asset allocations. It is this "stickiness" which makes them attractive for the sell-side of investment banks.

Pension funds were relatively slow to respond to the promotion of commodity derivatives as a new asset class. But between 2004 and 2010, the institutional sector poured hundreds of billions of dollars into indices and actively managed funds benchmarked against them.

Pension funds were encouraged by a strong sales effort and academic research such as "Facts and Fantasies about Commodity Futures," published by Gary Gorton and Geert Rouwenhorst in 2004, which appeared to show that a diversified long-only investment in commodity futures could produce similar returns to equities with similar risk, as well as protecting against inflation, and adding useful diversification to a portfolio.

Unfortunately, commodity futures have failed to match the return on equities, and proved increasingly poor diversifiers. Only the argument for inflation protection remains.

STICKY BUT NOT STATIC

While pension fund strategies tend to be sticky, they are not static. The years of under-performance are prompting a rethink, as well as a new set of sales pitches.

The most limited strategic response is to pick a more "dynamic" index which seeks to optimize the maturity and rolling of futures contracts.

A more radical strategy permits a more dynamic re-allocation of exposure between commodity markets either within the framework of an index wrapper or in a pure hedge fund type structure.

The most radical strategy is to allocate funds to a hedge fund with a wide mandate to take long and short positions.

Only the most radical, hedge fund long/short strategy is likely to work on a sustained basis. The others have already begun to compete away the returns to curve optimization etc as the strategies become more widely adopted.

The problem with hedge fund strategies is that returns are to the skill of the hedge fund manager rather than intrinsic to the commodities themselves. "Commodities" ceases to be a separate asset class of its own and becomes simply a sub-set of "hedge funds".

Institutions have found it notoriously hard to capture hedge fund returns, where most of the return has been captured by hedge fund managers themselves.

New pension-fund allocations to commodities as an asset class have slowed significantly over the last 18 months. Money that has already been allocated has increasingly been transferred from passive indices into more active indices, active managers, and even hedge funds.

The crucial question is whether fresh allocations will stop, and money already allocated eventually be withdrawn, if returns continue to disappoint.

Even if money already committed to indices is not pulled out of the asset class, it seems very likely fresh allocations will stop. Pension funds and their advisers, reviewing the performance of previous commodity investments over a three-year, five-year or 10-year horizon are unlikely to see a compelling case to invest, after the recent underperformance.

THE END OF FINANCIALISATION?

The end of fresh institutional investment inflows would profoundly affect commodity markets. The massive expansion of investors' involvement has supported an enormous increase in the number of commodity brokers and market-makers and a big build out of the major investment bank's commodity dealing divisions, as well as a substantial rise in staffing levels and associated services.

It has also driven a substantial "financialisation" of commodity markets and prices, increasingly correlations among different commodity prices as well as with other asset classes, promoting a more forward-looking expectations-driven approach to pricing.

Negatively, investors and financialisation have been blamed for unleashing a series of bubble-like price spikes and crashes. More benignly, they may have added to market liquidity and depth, supporting increased hedging over longer periods by both commodity producers and consumers, and enabling the markets to handle physical disruptions with less volatility than before.

If pension fund inflows stop, or go into reverse, all these aspects of financialisation could go the same way.

Predictions about the next phase in the evolution of commodity markets must be very tentative. But it seems likely the next few years will see a consolidation of market-making and brokerage services as the market matures. There are already signs of this happening, with the closure or downsizing of some of the second-tier commodity divisions at investment banks.

In terms of price behavior, the tight correlations among commodities and with other asset classes seem set to loosen (some already have) as remaining investors stress differences (on both demand and supply sides) rather than broad cross-commodity trends. Less positively, the trend towards increasingly liquidity may halt, or even reverse.

No one knows for certain. But there are signs the super-cycle theme and commitment of increasing long-term capital to derivative markets that dominated the past decade may be drawing to a close. As usual, the winners will be those who adapt fastest to the new era.

(John Kemp is a Reuters market analyst. The views expressed are his own)