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Commodities

investing

Russell OpenWorld

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The recent rises and alls in commodity prices have

been stunning. For eample, Brent crude topped $145 a

barrel in 2008 beore alling over 70% later that year; inAugust 2009 the price climbed bac over $70. Despite

the sharp declines, commodity indices have posted

healthy returns over the last decade, with the Dow

Jones-UBS Commodity Inde increasing 7.4% p.a. in

the ten years to 31 July 2009, compared to 6.1% p.a. or

global bonds and 1.8% p.a. or equities)1.

Unsurprisingly, commodities have received much

attention, with the current discussion embracing a wide

range o issues. Has the commodity price bubble burst?

How will commodity prices behave in the longer term,

in a world with constrained supply an ineorable global

economic development? How will commodity pricesaect the cost o ood and energy worldwide?

Moreover, ollowing the turbulence in equity and bond

marets over the last year, investors are looing to

assets such as commodities that can provide alternative

sources o growth and diversication to traditional

assets. Commodities have the added benet o providing

plentiul opportunity or active managers to add value

and their inclusion may help investors portolios

outpace infation. Interest in this asset class has been

urther boosted by the development o commodity

indices and the growth in number o credible providers.In this brochure we loo at the benets o commodity

investing, eamine the drivers o uture growth o

commodity prices and summarise how investors new to

this asset class can sensibly approach marets in which

prices demonstrate high volatility in the short term,

but whose undamental return characteristics are quite

attractive.

// P 1 Russell OpenWorld //Commodities investing

Access real assetsthrough commodityinvesting

Commodities can be a

superb complement to

bonds and equities.

As a long term investment,

commodities oer the

potential or attractive

returns, can reduce

ris through improved

diversication and may

help portolios to outpace

infation.

1 Source: Factset and Russell. All Total Return indices in USD. Bonds represented by the Barclays Global Aggregate Indeand equities by the Russell Global Inde. Past perormance is not necessarily a guide to uture perormance.

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Russell OpenWorld //Commodities investing // P 2

THE COMMODITIES MARkET

Maret trading in commodities has been occurring or

centuries. The Industrial Revolution encouraged theormalisation o echanges or trading in metal and

other commodities. Trading in commodity utures began

in the 1800s and the Chicago Board o Trade, the oldest

derivatives echange, was ounded in 1848.

Today, commodities cover a wide range o dierent

types o real assets, both in the developed and

developing world. See eamples in the table below.

So, how big is the commodities maret? Looing at

commodity utures alone, rom publicly available data

Energy Industrial Metals Precious Metals Agriculture Livestock

Crude Oil Aluminium Gold Wheat Live Cattle

Brent Crude Copper Silver Red Wheat Feeder Cattle

Unleaded Gas Lead Platinum Corn Lean Hogs

Heating Oil Nicel Palladium Soybeans Fat Hogs

Gas Oil Zinc Cotton Por Bellies

Natural Gas Iron Sugar Greasy Wool

Cocoa

published by Bloomberg LP and the US Commodity

Futures Trading Commission, you can etrapolate

roughly $300 billion in commodities utures openinterest as o December 2008. However, this gure

may be a raction o the maret: compare the $115

billion related to oil-related commodities to BPs

published gure o 1,332 billion barrels o proven oil

reserves, which at $60 a barrel implies a maret o

over $79 trillion or oil alone.

In contrast, the maret capitalisation o the Citigroup

Global Aggregate Inde (bonds) and the Russell

Global Inde (equities) in July 2009 were both just

over $30 trillion.

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the price o airline ticets, cruises, and tai rides may

not. The price o corn, soybeans, and wheat should

aect the prices o groceries, but such price increases

may be delayed by contracts, slow realisations o cost

increases due to ood processor hedging practices,

or simply reluctance by retailers to alter prices on a

requent basis. Ultimately, prices tend to be sticy

and may tae time to respond to changes in inputs.

As such, while the relationship between infation and

commodities is strong over the long term, over the short

term it will be potentially lagged and volatile.

// P 3 Russell OpenWorld //Commodities investing

THE CASE FOR INVESTING IN

COMMODITIESWe believe the strategic case or commodities investing

is predicated on three major benets:

Attractive long-term return prospects

Commodities prices are governed largely by demand

and supply conditions or physical assets. Prices are, o

course, heavily infuenced by changes in epectations o

near-term economic growth. However, over the longer

timerame we epect continued and increased demand

or commodities rom rapidly emerging economies lie

China and India. Global growth in population, estimatedto average 65 million people per year, will also support

commodity growth via an increased demand or energy,

ood and inrastructure.

Diversification

Commodities can be an important component o

an investors allocation to the general category o

real assets, alongside investments in real estate and

inrastructure. Commodities are used to eed and clothe

us, to build bridges and buildings, and to power our

homes and cars. They are physically scarce, and as such

can eperience positive price shocs even when other

assets, such as equities, are selling o.

Ultimately, as with other real assets, higher commodities

prices translate into higher costs or corporations just

as they represent higher costs or households. As such,

when commodity prices rise, manuacturers eel it in

their bottom line and consequently nancial marets

suer, and vice versa. The diversication potential

o commodities is logical and permanent; as such,

the benets associated with adding real assets to a

portolio o nancial assets should not be isolated to any

particular period.

Help portfolios to outpace inflation over the long

term

Commodities and other real assets orm a material

portion o the cost basis o production and household

epenses, so it is reasonable to assume that they can

oer an element o infation protection.

However, investors should note that infation and

commodity prices do not move in loc-step. While the

price o gasoline may rise in line with crude oil prices,

Over the long term, we

epect continued and

increased demand rom

rapidly emerging economieslie China and India.

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Russell OpenWorld //Commodities investing // P 4

THE kEY DRIVERS

Chinas ascent: China has ocused its attention onmaing signicant inroads into Latin Americas resource

rich economies. Her construction and energy companies

have undertaen a wave o mergers and acquisitions

within Chile, Peru, Brazil and Meico. In particular, they

have sought out companies involved in the production

o iron ore and copper so that they have the materials

to build the inrastructure required or the net

commodities boom.

Asian expansion: as Asias tiger economies continue

to develop, their demands or inrastructure and the

raw materials necessary to meet this demand willincrease maredly. The Asian Development Ban

concluded that developing economies in East Asia will

need to spend an estimated total o $165bn per year

between 2006-2010 in certain inrastructure sectors,

namely electricity, telecommunications, major

inter-urban roads, rail routes, water and sanitation.

The petrodollar: in the Middle East, the fow o

petrodollars is driving a huge amount o investment.

In Russia natural resource revenues fowing rom the

countrys deep oil and natural gas resources loo set

to be unnelled into diverse inrastructure projects,

including improving access to the Blac Sea resort oSochi in time or the 2014 Winter Olympics. Substantial

wor is also under way on Russias railways and the

countrys second electrication.

Demographic change: the epansion o the middle

classes in developing marets lie China and India has

seen growing consumption o meats (particularly por)

and processed oods in the ormer, while the latters

ats and oils consumption has increased. The rise

in hogs prices was arrested by an outbrea o swine

fu in April, but the ocus simply shited to alternative

oodstus. The worlds largest salmon armer, NorwaysMarine Harvest, leapt over 100% in the early months o

2009 on this basis.

Climate change: despite the all in commodity prices

late in 2008, strong economic growth over the past

ew years has granted resource-rich governments

signicant capital to dedicate towards inrastructure

investment. These economies generate disproportionate

demand, needing hard commodities such as steel,

nicel, tin and copper, or their industries and sot

commodities, such as cocoa, potatoes, wheat and barley,

to eed an increasingly urban population.

INFLUENCES ON PRICES

Environmental: Environmental infuences aresignicant, especially or the agricultural and energy

sectors. Desertication and increasing contamination

o water tables is liely to put pressure on agricultural

commodities, while energy commodity undamentals

must include a consideration or environmental

impacts.

Geopolitical: There are almost daily-emerging actors

which can epose the world commodity marets

to abrupt price changes. Eamples include soaring

soybean prices ollowing poor harvests in Argentina,

Brazil and Paraguay ater a series o droughts; the allin hog and rise in salmon prices ollowing the outbrea

o swine fu; and the idnappings o oil worers

in Nigeria driving up the price o oil over supply

concerns.

Currency: Many commodities are priced in US dollars

and, in 2008, some commentators attributed much o

the run-up in crude oil prices to the declining value o

the dollar. Elsewhere, precious metals, most notably

gold, have occasionally been treated by investors as

alternative currencies. This has led to a signicant

negative correlation between the metals price and the

value o the dollar.

Demographic change: Demographic shits, including

population growth, increasing global wealth and

changing diets particularly in the developing world

have had a dramatic impact on global demand or

oodstus and building materials. Eplosive demand

has led to increased prices and signicant concern

over the prospect o current and uture shortages or

some commodities, including wheat, rice, and oil.

Technological change: Technological change can have

a material impact on commodity prices, particularly

with respect to energy. Oil supplies are diminishing

and prices could increase as etractive processes

become ever more comple, maing alternative energy

more necessary. This could potentially put upwards

pressure on prices or materials associated with the

production o nuclear power, solar panels and wind

turbines.

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// P 5 Russell OpenWorld //Commodities investing

PASSIVE, ACTIVE AND SOMEWHERE IN-BETWEEN

For indirect eposures via commodity equity unds,

investors have the same passive or active management

options as in traditional equity unds. These are usually

available via specialist sector unds, such as energy and

metals. The options available via CCFs are less amiliar.

Passive CCF exposure

While passive investments in commodities have been

around since the 1980s, the prolieration o commodities

indices over the last 10 years has epanded the options

or investors seeing diversied commodities eposure.

The indees dier in their construction methodology,the number and types o commodities they include

and their weighting to dierent sectors, with energy

dominating many indees. There is no consensus on

the most appropriate inde but the S&P Goldman

Sachs Commodities Inde and the Dow Jones AIG

Commodities Inde are among the most popular.

Investors can gain passive eposure to commodities

by investing in a baset o utures, through Echange

Traded Funds and Echange Traded Notes, or via inde

swaps. The costs o investing passively in commodities

can be more epensive than passive strategies in other

asset classes.

Active CCF strategies

Active commodity management is no longer the

eclusive domain o Commodity Trading Advisors2 ,

and today there are dozens o sophisticated managers

employing a variety o undamental and quantitative

strategies. Active investing is a natural t with

commodities due to the periodic bursts o price volatility

and the participation o non-economic players (physicals

buyers and sellers or hedgers). Because hedgers are

motivated by production and consumption goals, sillulactive managers (economic players) have multiple

sources o alpha to eploit.

Be they long-only, long-neutral, long-short or CTAs,

managers can employ a variety o trading strategies to

capture the alpha available in commodities. While not

a complete list, the ollowing trading methods provide

an idea o the variety o strategies available to active

commodity managers.

GAINING ExPOSURE TOCOMMODITIES

Given that holding physical commodity

inventories (also nown as spot commodities) is

impractical or investors other than the end users

o the commodities, investors have traditionally

sought eposure to commodities through

utures marets or by a thematic investment in

commodity-related equities.

The primary method or obtaining an eposure

to commodities is via collateralized commodities

utures (CCFs). CCFs generate returns in three

ways:

spot return, which is the return associatedwith changes in current commodities pricelevels;

roll yield, which is the return rom replacingutures contracts as they near epiration; and

collateral management, which is the return on the collateral required or the uturescontracts.

Investors can also gain commodities eposure

through commodity-related equities or other se-

curities, oten pulled together into thematic equity

products. For eample, some commodities such

as uranium require equity maret participation

to gain eposure. Certain equity sectors possess

commodity maret eposure, such as:

shipping, ground transportation, and storage

securities;agri-business, timber production ortimberland;

energy inrastructure, mining, nuclear powergeneration, integrated oils or energy services;and

construction, abrication, materials securities.

For all intents and purposes, these investments

are no dierent to other equity sector unds.

2Commonly regarded as a type o hedge und, CTAs are active managers that ocus primarily on trends in commoditiesand other nancial utures marets. They can tae leveraged long and short positions in individual utures contracts.

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MANAGER UNIVERSE

While the rst active managers with a ocused andsystematic process or commodity investing emerged

in the 1980s, the number o providers has increased

substantially over the last ve years. The current

universe o enhanced inde managers consists o ten

or more; active long-biased managers and long-neutral

managers number roughly two dozen; and the collection

o ully active long/short and CTA managers is etremely

large, possibly in the hundreds.

While active management opportunities are plentiul in

the commodities marets, the ris and diculty can be

considerable. Commodity prices are highly volatile andthe long-term success o a commodities programme is

dependent on the sill and discipline o the management

team. O particular importance when hiring any

manager who trades in CCFs is a robust understanding

and eperience o the commodity utures maret, and

relevant actual trading eperience in that maret.

Russell OpenWorld //Commodities investing // P 6

Directional trades: In a benchmar-relative portolio,

individual commodity positions can be implemented as

either over or under weights relative to their weight in

the inde.

Spread trades: These strategies loo to eploit relative

value opportunities between dierent contract months,

echanges or commodities. These spread trades include

inter-month (e.g. April/August wheat), inter-maret (e.g.

Brent vs. WTI crude) and inter-commodity positioning

(crac spreads such as crude/gasoline). Spread trades

are typically implemented by taing a long position

in one commodity or contract month while shorting

another. Spread trades are the basis or the majority o

absolute return managers strategies.

Commodity volatility trades: Volatility trades are

typically used to epress a managers directional

outloo or a commodity, his epectations or uture

volatility, or to structure relative value trades similar

to those via outright spread trading. Volatility trades

are generally implemented via the options maret and

can include the sale or purchase o options based on

commodities utures.

Managers can also add value by smart timing o

utures rolling and enhancing the returns on collateral

investments via cash plus strategies. Enhancedinde managers usually ocus their attention to these

strategies.

Technical trading strategies

Finally, there are strategies which might be considered a

hybrid o active and passive management. For eample,

theoretical and empirical evidence demonstrates that

managers can systematically add value above standard

long-only commodity indices by ollowing a momentum

strategy. This advantage eists because o the structural

characteristics o the commodity maret, such as

storage costs and inventory levels which encourageserial correlation o commodity prices. Such a trend-

ollowing strategy can be implemented by managers

ollowing a nave inde-construction process which

ollows a dierent construction methodology to the

main indees available. Several eamples o such

indices are available, and sill is required to select the

most appropriate construction methodology in much

the same way that care should be taen when selecting

an active manager o commodities.

CONCLUSION

Despite the recent volatility eperienced

in commodities marets, we believe that

many investors should consider a

strategic allocation to commodities

in the contet o their long- term

investment portolios. Commodities can

generate signicant returns to investors,

oer signicant diversication benetsand their inclusion can help portolios to

outpace infation over the long term.

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