Commodities as an Asset Class: Delivering Beta and Beyond

With the rebound in the prices of such commodities as oil and gold after years of cyclical decline, is it now time to reconsider the place of commodities in your portfolio?

David-Michael Lincke, CFA, head of asset management at Picard Angst Ltd., said that commodities continue to offer many investors meaningful benefits through diversification, inflation protection, and absolute returns in his presentation at the 2015 CFA Institute European Investment Conference in London. While commodities are highly cyclical, investors should take that feature into account and exploit risk premium strategies that complement traditional beta strategies. Lincke also suggests that investors should be aware of a number of structural flaws in commodity indexes.

In this question-and-answer session following Lincke’s full presentation, he considers relative value, timing, liquidity, and some of the dangers of exposure to commodities.

A full version of this presentation is also available in the CFA Institute Conference Proceedings Quarterly.

Audience Member: Considering the collapse in oil prices, do commodities offer compelling value relative to equities and bonds?

David-Michael Lincke, CFA: Timing is the problem with any cyclical market. Volatility offers a good comparison. If volatility is high, it will come down. If it is low, it will go up. But if you buy exposure through VIX (Chicago Board Options Exchange Volatility Index) futures, this cycle is already part of the market-price curve. The situation is similar in crude oil. Investors are showing a lot of interest in taking exposure now because they believe that over the medium term or long term, prices will go up. After all, even as exploration is being scaled back — in the Arctic, for example — demand continues to grow worldwide.

The problem is that the forward curves are in a fairly significant contango. (Contango occurs when the futures price is higher than the current spot price. Under conditions of contango, the futures curve slopes upward with negative roll returns.) Investors have no way to replicate spot prices exactly, and they must pay a premium to take exposure. If the period of flat prices is prolonged, investors trying to time the market can lose a substantial amount of money. That situation can lead to an opportunity for other sources of return, such as long–short approaches, to take advantage of the structural negative yields that are now prevailing.

Is short-term timing important?

Investors who take a pure beta approach may want to think about timing, even though a sufficiently long-term perspective can help them earn a structural risk premium. The problem is that investors who claim to have a long-term time frame do not necessarily follow through on it. It is not easy to time these cycles correctly. A segment of commodity hedge funds are more oriented to the short term, but their recent performance has not been convincing.

How do you manage liquidity?

Liquidity in commodities is not a big issue. In fact, the deviations from asset value in exchange-traded funds (ETFs) are a bigger issue in the fixed-income world, especially given the tremendous growth in corporate bond ETFs and high-yield investments. Commodities are among the most liquid and transparent of investments, which helps explain their attractiveness.

What are the dangers in taking exposure to commodities?

In terms of taking exposure to commodities, there are two routes. One is through the exchange-traded derivatives markets, which have proven themselves to be quite robust. No major clearinghouse has ever gone bust. The other route is through the OTC market, where investors face counterparty risk. The volumes in the OTC market then show up on a hedging basis in the listed market.

The problems are on the regulatory side. For example, if retail investors want exposure to commodities in Europe, they typically invest in some kind of UCITS (undertakings for the collective investments in transferable securities) vehicle. But fund regulation has been structured without considering the characteristics of commodities. They are not usually eligible for investment. So, what takes place is regulatory arbitrage because it is permissible to invest in financial indexes. Commodity strategies can be shaped as a financial index, and then a swap is written on it to gain commodity exposure. Unfortunately, this strategy does nothing to protect retail investors. If anything, it increases costs and introduces additional counterparty risk.

Those are some of the major problems in terms of accessibility and unnecessary complexity in the asset class, which may contribute to systemic risks that recent regulatory efforts have been trying to address. On the institutional side, most investors do not want to take OTC exposure to commodities, so a typical request for proposal will limit solutions under consideration to those that invest directly on the exchanges, which is the most cost-effective approach. It is very difficult to structure a product that fulfills the requirements of both institutional and retail investors.

The CFA Institute European Investment Conference will be held 7–8 November 2016, in Amsterdam, Netherlands.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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