COMMODITIES – THE CYCLE, THE ASSET CLASS & THE ALLOCATION

This note is an attempt to briefly run over the ‘state of play’ in the commodity cycle. Where commodities may be deemed to fit as an asset class in a portfolio and the pros and cons of active vs index investment allocation, within that asset class.

With equity markets at all-time highs, volatility hitting all-time lows and the fact that we’re well into the 6th year of a commodity bear market, the question is whether the worm has turned?

Where are we in the commodity cycle?

In the beginning…

Broadly speaking commodities are, of course, not a new investment vehicle. Physical commodities have been traded for as long as the civilised world has existed, coming to the fore when humans began to live in concentrated and fixed areas such as cities.

Wheat has existed for at least 9,000 years, born from the middle east. Rice from China and Corn from central America have been cultivated over a similar period. However, the modern form of commodity market is a relatively new phenomenon.

Even though the first futures contract, as we would know it today, evolved 150 years ago when farmers and dealers began to commit to future exchanges of grain for cash, it was only as little as 20 years ago that the general investment world gained real access to the commodity market, for the most part, through stocks. The first commodity futures mutual fund only came about in the late 90’s, with the first physical commodity exchange-traded fund (ETF) in 2004.

These markets have now of course matured, with the bulk of commodity trades running through index-linked instruments (like ETF’s), all of which has allowed us to more easily gauge market moves.

…and now?

In terms of our current situation, we now find ourselves 6 years into a bear market, post the Chinese driven commodity supercycle peak of 2011.

Commodity cycles tend to follow economic cycles, and global growth has continually disappointed since the financial crisis. During my tenure at Macquarie Bank, the former head of research, Tanya Branwhite, called it “the long grinding cycle” and although she was referring more to equities, her view was spot on in the broader context also. Combined with increased production capacity, driven by the China boom, we have been met with both over-supply of a broad bucket of commodities as well as a slowdown in demand growth.  

All, however, may not be doom and gloom. Historical data would suggest that the average duration of a commodity downswing is around 7 years, with price declines averaging minus 40% (research by the IMF & Capital Economics from period 1950 to 2014).

The reasonably broad-based Bloomberg Commodity Index is currently showing levels not seen since 2002 and, although we had experienced a ramp up in production driven by the last boom, we are now witnessing a reversal, with a convergence between rising production costs and falling market prices.

This may all signal that, combined with significant price declines in a number of commodities over the last few years, we’re approaching a sentence I’m always somewhat reluctant to whisper…that we may be somewhere near the bottom of the current cycle.

Commodities as an Asset Class

Due to the relatively recent nature of commodities as a readily available investable asset, the investment world is still at some odds as to how to classify them. Most will agree that a reasonable definition of an ‘Asset Class’ is one of investments that exhibit similar risk and return characteristics that we can standardise, in order to benchmark them. Stocks & Bonds are an example of this. Commodities, however, tend not to behave themselves on this front, which can be seen by simply comparing differing commodity indexes.

To counter this, many allocators have simply deemed commodities as an ‘Alternative’, as they don’t tend to represent an asset class that is found in most traditional portfolios.

Whichever bucket you wish to allocate commodities to, one assertion that is reasonably agreed upon throughout is the broad-based benefit of investing in them - with most allocators considering commodities in their strategic asset allocation for either diversification purposes, to increase portfolio returns or as a form of protection from inflation.

Diversification; If you look at commodity benchmarks over the long term you will find a relatively low correlation with more traditional asset classes and that, historically, the addition of commodities to equity/bond portfolios results in an increase of risk-adjusted returns.

Though this was not true in the aftermath of the financial crisis, when a temporary pick-up in the correlation between equities and commodities due to a decline in aggregate demand over a number of asset classes. Commodities are once again responding to more fundamental supply/demand factors including geopolitical instability (think oil), mining strikes (think BHP’s Escondida mine) and even weather (El Niño with grains and natural gas). 

Source: Bloomberg.

Protection from Inflation; Commodities can offer an effective way to hedge a portfolio against any inflation shocks. Food and Energy prices tend to be the drivers of inflation. Commodities are the asset class that drives these changes - so any unexpected volatility expressed by CPI (Consumer Price Index) moves will generally be absorbed and, in fact, commodities will often exhibit an outsized response and increase above CPI figures. They are, of course, also priced in USD - so commodity prices tend to rise when the value of the dollar falls.

Absolute Return; With a suitable investment strategy that takes into account the cyclicality of commodities, most broad-based commodity portfolios exhibit equity-like risk adjusted returns over the long term. Most Commodity managers either look to exploit these cyclical opportunities, or take advantage of opportunities in futures markets.

Drivers of return include the ‘risk premium’ earned for absorbing short term volatility. The ability of managers to rebalance a commodity portfolio, which is especially true in today’s markets, with huge divergence between individual commodity performance and ‘Roll Return’, with managers able to take advantage of rolling futures contracts.

The Allocation; Active commodity alpha strategies vs passive commodity indexing

Passive

There is still a valid argument for a positive long-term outlook for commodities, with demand likely to come from emerging economies for years to come. Passive funds track an index or market, rather than try to beat it. So, if you have an overall positive opinion on the sector with a long-term view and time horizon, passive investment can make sense.

Unlike in most active strategies, passive investing in commodities can act as a form of protection from inflation.

It’s worth noting, however, that inflation sensitivity varies across commodity sectors. For example, over the long-term, energy and industrial metals tend to exhibit the highest inflation beta – vs something like cobalt that doesn’t necessarily follow suit closely (up well over 100% in the last 12 months).

Fees…don’t forget about those fees. Passive investing usually comes at a discount to paying for active managers who are trying to beat the market or play on a theme as there is less trading involved and required in the investment process. The difference in fees may initially seem small but, compounded over years, the impact on investment returns can be significant.

The simplicity of many passive or index funds can also offer comfort to an investor - as they know what they are investing in…something that tracks an index. This is unlike Active managers, where it is often difficult to pick the good from the bad, or even sometimes the ugly.

Active

Commodity returns may be enhanced through active management seeking to avoid the inefficiencies of passive commodity indexing as well taking advantage of any additional opportunities within complex markets.

Commodity markets can offer fertile opportunities and alpha generation for capable managers. This is especially true for managers who can design a portfolio that combines both fundamental trades and structural trades that seek to capture recurring risk premiums and that invest in non-directional return sources using techniques such as arbitrage, momentum, volatility and roll yield.

They also avoid being handcuffed in terms of what to invest in. For example, with the majority of passive commodity index funds, commodity indexes tend to be weighted to commodities with the largest trading volume or greatest consumption globally, much like Equity Indices that are weighted to the largest companies. This means that investors are usually exposed to overweight or concentrated positions in energy commodities. Active managers are not.

Moreover, Active managers don’t necessarily rely on prices rising. Employing a ‘relative value’ approach and trading price inefficiencies between related instruments is an example of this.

For instance, copper prices rallied on both the LME (London) and COMEX (New York) exchanges towards the end of 2016. However, the COMEX price was pushed to a short term premium Vs the LME. By employing an arbitrage trade, buying on the LME and selling on COMEX, the strategy’s net exposure to the metal is roughly zero (so risk limited), and the gain was made once the arbitrage reversed.

Source: Bloomberg, Arion Investment Management Limited.

It is worth noting, however, that Active type strategies lose the natural hedge against inflation that long-only commodity strategies can offer; as are usually non-directional, sometimes trade volatility and are not weighted according to an index. 

Overview

As per the second paragraph of this piece; with equity markets at all-time highs, volatility hitting all-time lows and the fact that we’re well into the 6th year of a commodity bear market, the question is whether the worm has turned?

Only time will tell. What we do know is that we’re currently reaching a few milestones that have previously indicated a change in the cycle.

Watch. This. Space.

Source: Bloomberg, Arion Investment Management Limited.

Author, James Purdie: Head of Investor Relations

Disclaimer: Although this document has been issued by Arion Investment Management, it is important to note that the views of the author may or may not represent that of the company. The document has been derived from sources believed to be current and accurate as at the date of release. The comments made are general in nature and do not take into account anyone’s personal needs, financial situation or requirements and past performance is not an indicator of future returns. Before acting upon anything associated with this document we would recommend seeking advice from your financial advisor.   

About the company; Arion Investment Management Limited is a commodity focused investment management company, based in London. The company is authorised and regulated by the Financial Conduct Authority (registered no. 742037).