the portfolio benefits of commodity index...

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The Portfolio Benefits of Commodity Index InvestingAnalysis and Outcomes

March 2012

PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. 1

Assets under management in commodities has about tripled since the low in 2008

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Source: Societe General , Cross Asset Research, Commodities Investment Flows, March 2012


In a Barclays Capital commodity investing survey of over 100 institutional investors….

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Source: Barclays Capital, Commodities Research, Commodity Cross Currents Commodity investing to rebound, February 2012

“For more than 70% of the survey the appropriate long-term average weighting for commodities in a portfolio is over 6%, a long way above current norms. “


What are the historical benefits that has driven investments in commodities as an asset class?

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• Diversification� Low correlations to stocks and bonds

• Inflation Protection� Positive correlation to inflation AND changes in the rate of

inflation

• Risk/Return Profile� Equity-like risk and return

Source: PIMCO


What is an asset class?

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There are no conclusive definitions of an asset class

� Super Asset Classes1

1. Capital assets• Stocks, bonds, real estate

2. Consumable/transformable assets• Commodities

3. Store of value assets• Currency, fine-art

� Beta (Market) Exposures2

1. Exposures that produce a return NOT based on skill• Financial markets, interest rates, credit spreads, volatility

Source: Ibbotson Associates 2006, Strategic Asset Allocation and Commodities, Commissioned by PIMCO and Prepared by Thomas M. Idzorek. http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/Commodities.pdf

1.Greer (1997) PIMCO

2.(Ibbotson [2006], Anson [2002], Waring and Siegel [2003,2005] and Dopfel [2005])


What makes COMMODITIES an asset class?

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Commodities offer an inherent or natural return that is not conditional on skill. Coupled with the fact that commodities are the basic ingredients that build society, commodities are a unique asset class and should be treated as such.

Source: Ibbotson Associates 2006, Strategic Asset Allocation and Commodities, Commissioned by PIMCO and Prepared by Thomas M. Idzorek. http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/Commodities.pdf

1.Greer (1997) PIMCO

2.(Ibbotson [2006], Anson [2002], Waring and Siegel [2003,2005] and Dopfel [2005])


Futures are the most practical way get direct commodity exposure

• Direct investing- buy the commodity and store it (Cash or Spot Market)� How would you store 40,000 pounds of live cattle or 1,000 barrels of oil?� Not practical for most investors

• Equities of commodity producers (RIO, BHP)� Less direct commodity exposure

� Less diversification, inflation protection � Higher exposure to broad stock market movements� Influenced by management decisions

� May hedge out commodity exposure� May provide exposure where futures markets are less tradable

� Timber, Water, Steel, Coal• Futures contracts

� Most direct and practical solution� Exchange-traded contracts offer uniformity and are regulated� Provides the inherent asset class return

Investors may choose to get commodity exposure by directly investing, using futures contracts or by using equities, but may not capture the asset class return


A special quality makes commodities tradable

• Commodities are fungible, raw materials used to produce the products consumers buy, from food to furniture to gasoline.

– Some examples include crude oil, natural gas, corn, wheat, cattle, aluminum, copper, and gold.

• Where the raw materials trade for cash is called the “Spot Market”


• Supply > Demand => Excess => Spot Price Declines• Demand > Supply => Shortage => Spot Price Increases

Supply and demand drive commodity prices in the spot market

Source: Gunzberg, J. and Kaplan, P., 2007, “The Long and Short of Commodity Futures Index Investing: The Morningstar Commodity Index Family”, Chapter 10 in H. Till and J. Eagleeye (eds), Intelligent Commodity Investing, p 245.


Futures Contracts

•What is a futures contract?A standardized agreement between two parties.– The buyer agrees to buy and the seller agrees to deliver (sell) the

underlying asset at a specified price on a set future date or expiration date.

– Most positions are closed before expiration to avoid delivery.– The futures contracts in indices are exchange-traded and regulated.

•Futures prices are directly related to spot prices

•The collection of futures contracts with the same underlying commodity but different expiration dates make up a forward curve.

– Storage situations drive the relationship between futures contracts with different expiration dates.


“Risk premium” 2¢

Futures contract prices are directly linked to expected spot market prices

SOURCE: PIMCOSample for illustrative purposes only.

October

65¢ Producer’s break-even

70¢ Acceptable profit72¢ Expected cash price

84¢

60¢

Potent ial range of c ash price of c attle in cents per pound

February

67¢Current

cash price

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For what risk does the index investor get paid?

The futures markets exist to facilitate hedging, not to forecast prices

• Investors Earn An “Insurance Premium”– Monetize this risk by owning commodity futures contracts

• Producers need protection against price drops – Excess short hedging– Keynes theory of “normal backwardation”

• Sell production forward at a discount => downward price pressure

– Hicks theory of “congenital weakness”• Producers are more vulnerable than consumers

Source: Till, H. and Gunzberg, J., 2006, “Absolute Returns in Commodity (Natural Resource) Futures Investments”, Chapter 3 in I. Nelken (ed), Hedge Fund & Investment Management.


Fundamental sources that drive the commodity asset class returns

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SOURCE: PIMCOSample for illustrative purposes only.

T-Bill Rate

Expected Inflation(plus real rate of

return)

Risk Premium

Price Uncertainty (producers vs. processors)

Unexpected GeneralInflation

(plus... Individualmarket “surprises”)

ExpectationalVariance

Uncorrelated Volatility

(mean reversion)

Rebalancing

Low InventoryRelative to Demand

ConvenienceYield

Components of Return

Causes of Return


Commodity indexing captures the asset class return

In order to obtain the market return or beta from commodities,index investments should measure returns from a process that:

� Constructs and calculates with a passive, specified method� Considers only exchange-traded futures contracts on physical commodities� Assumes only long positions� Collateralizes each position fully

Source: PIMCO


S&P GSCI Index – PURE BETA

• Weighting Scheme– World production-weighted

• Constituents (24)– Must meet eligibility criteria on an annual basis– Futures contracts on physical commodities – Total Dollar Value Traded (TDVT) minimums– Reference Percentage Dollar Weight minimums– Denominated in USD and Trading Facility Organization for Economic Cooperation and

Development (OECD)– Pricing and volume availability

• Sectors (5 groups)– Agriculture, Energy, Livestock, Precious Metals, Industrial Metals

• Rebalance– Annual rebalance, Monthly review

• Roll– 20% each day of the 5th through 9th S&P GSCI Business Days of each month– Next nearby most liquid contract

Information as of December 30, 2011


• The historically higher energy weight stems from the production weighting that potentially leads to greater diversification, inflation protection, and liquidity

S&P GSCI Index – PURE BETA

S&P GSCI SectorIndex Weight as of

12/30/2011 (%) Agriculture 14.7Energy 70.5Industrial Metals 6.6Livestock 4.7Precious Metals 3.5

Futures VolumeCrude Oil 9,993,642 Natural Gas 5,878,263 Corn 4,055,191 Comex Gold 2,901,868 Heating Oil 2,619,425

CME Group Exchange Volume Report - Monthly Dec 2011 Sample Volumes

Source: S&P Indices and CME Group at http://www.cmegroup.com/wrappedpages/web_monthly_report/Web_Volume_Report_CMEG.pdf


Source: Standard & Poor’s, Bloomberg. Data as of February 29, 2012. Charts are provided for illustrative purposes. Past performance is not a guarantee of future results. This chart may reflect hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

Performance varies across commodity indices

Exhibit 1: Index Total ReturnsTotal Return

February 2012 YTD 12-

Month 3-Year 5-Year Since 1999

S&P GSCI 6.06% 8.43% 0.23% 55.05% -7.64% 91.23%

S&P GSCI Enhanced 6.07% 8.47% 0.04% 63.73% 16.93% 355.37%

S&P GSCI 3-Month Forward 5.85% 8.52% -0.01% 64.63% 19.83% 373.20%

S&P GSCI Dynamic roll 4.32% 7.72% -1.48% 54.77% 37.39% 513.22%

S&P GSCI Light Energy 3.86% 7.08% -6.39% 50.03% -2.45% 65.71%

S&P GSCI Covered Call Select 2.14% 3.65% -11.67% 42.32% 21.07% na

S&P World Commodity Index 7.11% 12.52% 7.07% 100.01% 32.70% 338.53%

S&P Systematic Global Macro -0.11% 3.54% -1.34% 30.49% 78.53% na

Although the S&P GSCI is considered the simplest beta, many indices have modifications that may affect performance.


Source: Russell Investments // Active Commodity Investing. Russell Research by Lee Keyser, Research Analysthttp://www.openworldinvesting.com/files/active_commodity_investing.pdf

Active strategies have many choices of fund structures and implementation options

• Long-only products� utilize curve strategies� under/overweights to commodity sectors and individual commodities

• Long-neutral products� tactically allocate to cash

• Long-biased products� allow limited shorting

• Long-short products� benchmark-agnostic and seek absolute returns� use spread trades and outright long or short directional bets

• Specialist managers� limit investments to specific sectors

• Thematic strategies� employ long-term macro views on commodity sectors


Source: Russell Investments // Active Commodity Investing. Russell Research by Lee Keyser, Research Analysthttp://www.openworldinvesting.com/files/active_commodity_investing.pdf

Risk factors to consider in active commodity investing

• Liquidity� Large position sizes� Over-the-counter derivatives

• Collateral management� Invest collateral opportunistically� May use leverage

• Credit/counterparty risk� May use custom derivatives

• Speculative limits� Size and implementation strategies may be disrupted

• Delivery risk� Non-commercial players may get “squeezed” during delivery

• Model/analytics risk� Many risk systems only handle stocks and bonds appropriately


1. Source:http://www.nfa.futures.org/nfa-registration/cta/index.html

Many active managers use more than just commodities

A Commodity Trading Advisor (CTA) is an individual or organization which, for compensation or profit, advises others as to the value of or the advisability of buying or selling futures contracts, options on futures, or retail off-exchange forex contracts.1

What does this mean?

A CTA registers with the National Futures Association (NFA) so that it is regulated by the U.S. Commodity Futures Trading Commission.

WHY IS THIS SO CONFUSING?!

The word “commodity” in CTA doesn’t reflect what the strategies are trading! The CTA’s are trading any futures contracts including ones on stocks, currencies, interest rates, fixed income, and commodities.


Implications of active strategies versus passive

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Commodities have provided diversification from equities and from nominal bonds

Source: S&P Indices. S&P 500, BarCap US Agg , and S&P GSCI represent Stocks, Bonds, and Commodities, respectively.

In only 4 years from 1970 through 2011 did both the S&P 500® and the S&P GSCI drop in value.

Correlations on Monthly Returns from 1/76-12/11S&P 500 BarCap US Agg S&P GSCI

S&P 500 1.00 0.23 0.17

BarCap US Agg 0.23 1.00 (0.02)

S&P GSCI 0.17 (0.02) 1.00


Commodities have provided diversification during historical crises

– Commodities provided diversification during a political crisis

• Persian Gulf War

– Commodities provided diversification during a financial crisis

• Black Monday

Sample for illustrative purposes only.SOURCE: Goldman Sachs, Bloomberg Financial MarketsRefer to Appendix for additional chart and index information.

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S&P GSCI VS. S&P 500

60

80

100

120

140

160

Jun '90 Jul '90 Aug '90 Oct '90 Nov '90 Dec '90 Feb '91 Mar '91

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S&P GSCI S&P 500

S&P GSCI VS. S&P 500

60

70

80

90

100

110

Sep '87 Oct '87 Oct '87 Oct '87 Oct '87 Oct '87 Oct '87

Grow

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S&P GSCI S&P 500


This pattern has led to increased portfolio efficiency and capital preservation

Source: S&P Indices. S&P 500, BarCap US Agg, and S&P GSCI represent Stocks, Bonds, and Commodities, respectively. Monthly return data.

Historical Performance for Hypothetical Portfolios from 1/76-12/11

Portfolio 1 Portfolio 2 Portfolio 3S&P 500 100% 50% 40%BarCap US Agg 50% 50%S&P GSCI 10%Annualized Return 7.28% 7.77% 7.78%Annualized Risk 15.27% 8.71% 7.77%Sharpe Ratio 0.48 0.89 1.00


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Portfolio 1 (100% S&P 500)Portfolio 2 (50% S&P 500, 50% S&P/BGC 7/10 Yr T)Portfolio 3 (40% S&P 500, 50% S&P/BGC 7/10 Yr T, 10% S&P GSCI)

This pattern has led to increased portfolio efficiency and capital preservation

Portfolio 1 Portfolio 2 Portfolio 3Annualized Return 0.92% 4.03% 4.50%Annualized Risk 15.93% 7.61% 7.26%Sharpe Ratio 0.06 0.53 0.62

Historical Performance for Hypothetical Portfolios from 1/02-12/11

Source: S&P Indices. S&P 500, S&P BG/Cantor 7/10 Yr. U.S. Bond, and S&P GSCI represent Stocks, Bonds, and Commodities, respectively.


There have also been low correlations between sectors which has benefited well-diversified indices

Source: S&P Indices. S&P 500, S&P BG/Cantor 7/10 Yr. U.S. Bond, and S&P GSCI represent Stocks, Bonds, and Commodities, respectively.

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In only 4 years since 1984 did all of the sectors move in the same direction – and that direction was positive.


Commodities have provided protection from inflation

S&P GSCI yoy% and CPI yoy Index have 0.68 correlation since 1991 and 0.75 correlation in the past 10 years

Source: S&P Indices and United States Department of Labor, Bureau of Labor Statistics. http://www.bls.gov/cpi/


Commodity index investments may provide a levered response to inflation

SOURCE: PIMCO, Bloomberg, "Facts and Fantasies about Commodities Futures": Gary Gorton and Geert Rouwenhorst (rolling 12-month calculations)Bolded numbers above (representing inflation beta) are measured by CPI-U and numbers in parentheses are r-squared.R-squared signifies the percentage that inflation explains of the variability in commodity index returnsInflation beta can be interpreted as: (using DJUBSCI 1992-2009 as an example) A 1% increase in inflation results in 10.8% increase in return of the DJUBSCI during the period from 1992–2009Time periods shown reflect inception of G&R data (1960), first full year of returns for the S&P GSCI (1971), first year crude oil was included in the S&P GSCI (1987) and first full year of returns for the DJUBS CI (1992)“G&R” refers to Gorton and Rouwenhorst, who constructed an equally-weighted collateralized futures index with data through 2007.Hypothetical example for illustrative purposes only.Refer to Appendix for additional hypothetical example, index and risk information.

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INFLATION BETASPGSCI DJUBSCI G&R*

1960–2007 1.6 (0.08)

1971–2007 1.1 (0.02) 1.5 (0.06)

1971–2009 2.8 (0.11)

1987–2007 8.7 (0.18) 4.1 (0.14)

1987–2009 13.7 (0.50)

1992–2007 11.7 (0.13) 7.6 (0.14) 7.5 (0.23)

1992–2009 17.0 (0.50) 10.8 (0.46)

A dollar of commodities may hedge more than a dollar of the portfolio from inflation


Source: Russell Investments // Active Commoditiy Investing. Russell Research by Lee Keyser, Research Analysthttp://www.openworldinvesting.com/files/active_commodity_investing.pdf

Virtually everyone is short commodities so to investing through indices may provide protection

There is a simple reason everyone might want to invest in commodity indices to capture the asset class return…

If you buy products like gas, food, and clothing, then you are a consumer.

Remember consumers are “short” commodities so owning them through an index may at minimum protect against price spikes and hence provide insurance.


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