The Portfolio Benefits of Commodity Index ?· PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. 2 In a Barclays Capital commodity investing survey of

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  • Analytic services and products by Standard & Poors are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poors has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process.

    Analytic services and products by Standard & Poors are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poors has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process.

    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 & Poors. 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

  • PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poors. 2

    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.

  • PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poors. 3

    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

  • PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poors. 4

    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])

  • PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poors. 5

    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])

  • PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poors. 6

    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

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    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

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    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.

  • PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poors. 9

    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.

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    Risk premium 2

    Futures contract prices are directly linked to expected spot market prices

    SOURCE: PIMCOSample for illustrative purposes only.

    October

    65 Producers 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

    67Current

    cash price

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  • PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poors. 11

    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.

  • PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poors. 12

    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

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    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

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    S&P GSCI Index PURE BETA

    Weighting Scheme World production-weighted

    Constit