Download - Brochure Commodities Investing 2009 08
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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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