Commodity investment has become increasingly popular over the past few years, as the associated benefits have become more widely known. As global growth has continued unabated, led by the new economic powerhouse of China, commodities have been consumed at an unprecedented rate. With the rise in demand and problems of tight supply, prices have risen across most of the commodity spectrum.

Commodity investors, both passive and active, have enjoyed an above-trend performance. However, unlike in previous bull markets, commodities are no longer just the preserve of institutional portfolios, and there are now many products available for the retail investor. Moreover, with strong returns, significant newsflow and several available investment vehicles, investment money has poured into commodity markets.

Diversification
Commodities offer many different characteristics to other asset classes and are, therefore, an excellent portfolio diversifier, no matter how large or small a portfolio. Table one shows the correlation of commodities with equities and bonds over the past decade and, as can be seen, commodities show little correlation to the main asset classes over the period.

The reasons for this are fundamental. Unlike bonds, commodities are real assets and tend to hold their value in the face of inflation. Similarly, they are physically scarce and, as such, experience positive price shocks at times when other asset classes, such as equities, sell off. The war premium applied to the oil price is a pertinent example of how commodities can actually be an effective portfolio hedge in uncertain times. Therefore, their inclusion in a balanced portfolio can help generate strong absolute returns with less risk.

Many investors, however, have been surprised that recent returns from their commodity investments have not matched the rises in underlying prices. Since the early 90s, the primary avenue available for investing in commodities has been traditional indices. These indices performed well for a period, but over the past few years it has become increasingly clear that their performance has been different to that of the commodity spot (cash) price.

The futures market
When investing in a commodity index, the money is not actually invested into the commodity spot market, as this would imply that the physical commodity is purchased and stored at great cost. Passive money is instead invested in the futures market, and the purchaser of a futures contract is obligated to purchase the physical commodity at a specific future date.

Before the future matures and the purchaser actually has to buy the physical asset, it is sold and the money is reinvested or ‘rolled’ into a new, longer-dated contract – and the process starts again. As the fundamentals that drive the physical market should be similar to the fundamentals in a month’s time, the one-month future’s price tends to move with the spot price. Therefore, investing in an index that tracks the one-month future gives a similar exposure to the physical commodity. However, the problem comes when the future’s price does not follow the spot price and this has exposed passive investing as a flawed strategy.

Passive investing
The vast majority of participants in commodities are passive investors or hedgers. These non-price sensitive participants have inadvertently created opportunities for active investors and, as such, this asset class is ripe with opportunities to outperform the passive participants.

The main problem stems from the fact that so much money now tracks the passive indices such as the S&P Goldman Sachs index and DJ AIG index. Approximately $150 billion (£74.26) buys and sells the near-month future in a clear and well-publicised roll schedule every month. This is a process whereby a future’s position is sold prior to its expiry to fund the purchase of a new position that will expire at a later point. This position is held until the future matures and then the process starts again. This clearly defined buy-and-sell process is referred to as the roll schedule. But with so much money chasing one particular contract at the same time every month, the futures price becomes distorted from the physical market. Any active investor worth their salt should be able to benefit from this at the expense of the passive investors.

Even without passive price distortions, the mechanical monthly roll can lead to returns that are dissimilar to the physical market. In a normal (contango) market, the future price of a commodity should be slightly higher than the spot price, with the price differential reflecting the effective cost of commodity storage for the period. For the passive index investor buying the one-month future as it matures and approaches the spot price, this leads to a loss on the future position as the investor ‘rolls down the curve’. Even if the spot price remains unchanged, the negative roll leads to a loss on an indexed position.

However, if there is a commodity shortage, this situation can often reverse. When supply is constrained, consumers of commodities are prepared to pay a premium upfront for delivery of the asset to ensure that they can continue to stay in business and as such the spot price can often rise above the future’s price (backwardation). In this scenario, passive investors are rewarded as their future’s position rolls up the curve towards maturity.

Uncertain markets
As commodity production is fraught with problems (war, weather, cartels etc), commodity market supply is at best inconsistent, and this uncertainty is played out in the futures market. An active investor can take advantage of these swings by being more selective about the commodity future they buy. In normal market periods, commodity futures curves tend to slope upwards, but at a declining rate. Table two shows that by rolling on a different part of the curve, one can reduce the effects (in this case a loss of $0.6 vs $0.4 per barrel of crude oil) of the negative roll yield and thus increase overall return.

However, a subjective view has to be taken as to what is the best part of the curve at which to act and it is in such instances that an active investor or fund manager can add value. A passive investor that sticks to a mechanical roll schedule every month exposes himself to the uncertainty and peculiarities of the futures term structure.

Weighing up the pros and cons
Commodities offer you a wonderful opportunity to diversify your portfolio, while benefiting from the long-term scarcity, and therefore performance, of the asset class. Commodities, however, are not, and never will be, as efficiently traded as other asset classes. The peculiarities of supply and demand and the presence of non-price sensitive players imply that there will always be persistent alpha opportunities. The passive investor will not only miss out on these opportunities, but quite often supplies the opportunity to the active investor by blindly following an index and distorting the market.

Commodities should always be considered as part of a balanced portfolio, but given the complexities and opportunities, selecting the right vehicle is very important in determining the end benefit. Therefore, looking beyond the traditional indices is often worthwhile.