Kevin Hall, Principal and Chief Investment Officer Hadrian Partners, Ltd
Has the continued asset flow into commodity-based products simply been another case of institutional investors seeking higher, uncorrelated returns, or is there a deeper economic story?
The expansive use of portfolio theory, a favourable global economic backdrop and geopolitical risks have driven institutions to embrace commodity market investment, leading to an aggressive flow of capital over the last several years into commodity index funds and similar vehicles. Traditionally, institutional asset management was centred on the capital markets, where money was allocated to cash, bonds and/or stocks based on an expected risk/return profile. Investment decisions were mostly de-leveraged and long-only. Over time, fuelled by shifting market conditions and financial innovations, institutions sought to improve their asset/liability management and worked to obtain reliable absolute return streams with minimal volatility. Investment policies were expanded to include more diverse trading strategies such as long/short equity, credit, relative value fixed income and global macro. However, while these strategies provided greater diversification and a steadier risk/return profile, their returns were still correlated with traditional capital market assets. Returns were a function of changes in equity prices, the direction of interest rates, volatility shifts and movements in credit spreads.
The Fundamental Argument for Commodities
Commodity markets have provided institutions with the ability to diversify away from capital markets and a mechanism for more powerfully utilising the benefits of modern portfolio theory. Historically, commodity markets have not correlated to the capital markets. This has allowed investors to add return while reducing risk when combining commodity investments with a portfolio of stocks, bonds and cash or other capital market-based strategies. Geopolitical and global economic events post-2000 quickened the interest in commodity investments. A number of themes raised commodities to a legitimate and desired asset class:
The popping of the stock market bubble, corporate governance issues and poor equity returns between 2000 and 2002 created an environment for equity market avoidance;
The tragic events of September 11 and the Iraq War put a spotlight on geopolitical uncertainty, boosting the appeal of precious metals as a store of value, and highlighting the potential threat to the global energy supply due to Middle Eastern instability;
Outside the Middle East, energy insecurity was also elevated by the active hurricane season of 2005, with the resulting, devastating impact of Hurricane Katrina on US production and distribution channels;
Weak commodity prices in the 1990s diminished mining capacity, while the emergence of China and India as hyper growth economies boosted the demand for raw materials, which helped to create a bullish commodity supply/demand imbalance;
The global economy entered a cyclical upswing after the 2000/2001 US recession, and the US housing boom of the early- to mid-2000s complemented an already strong Asian demand for raw materials such as copper;
The dramatic decline in interest rates in the US during the early 2000s, culminating with a 1% fed funds rate, drastically reduced the opportunity cost of holding commodities, which fail to pay interest or dividends;
The Bank of Japan enacted a 0% interest rate and ultra-easy monetary policy to fight off deflation and boost domestic economic growth, and a by-product of this policy was a flooding of the global economy with abundant liquidity, laying the seeds for inflation.
The Growing Bias to Minimise Exposure to Traditional Asset Classes
At the same time, commodity investment found increasing investor appeal, the drivers of capital market returns became benign, creating a lower return environment for stocks and bonds.
The treasury yield curve became relatively flat, reducing carry trade opportunities in the fixed income markets, additionally, fixed income volatility moved lower;
Treasury market volatility dropped and the Merrill Lynch Treasury Market Volatility Index, MOVE, saw levels below 80 bps, unprecedented since the index’s inception in 1988;
Credit spreads narrowed, as evidenced by the Moody’s Baa Corporate/10-year Treasury yield spread trading below 200 bps for the first time since October 2004;
Equity volatility compressed, the VIX spent long periods of time ranging between 10% and 12% and public interest in the equity market also waned, reducing flow and trading opportunities.
All Commodity Investments are not the Same
Commodities have proven to be a powerful investment vehicle relative to equities and a more efficient means of exploiting investment themes.
Investment returns in physical commodities outpaced the return of commodity-based equities. Between December 2004 and December 2006, un-leveraged spot gold rose 45.2%. By comparison, popular gold stocks Newmont Mining and Barrick Gold fell 1.6% and increased 26.8%, respectively, over the same period;
Futures contracts in tangible commodities provided efficient use of capital via leverage and the use of margin. Futures markets allow institutions the ability to have the financial equivalent of owning a commodity or basket of commodities and to invest the difference between the notional value of the commodity contract and margin. The commodity industry was quick to re-enforce the benefits of commodity investing and moved to show that commodity returns could be positive over time when collateralised. The Goldman Sachs index is just one such example;
The acceptance of commodities as an investment class has been further highlighted by the proliferation and success of commodity-based ETFs. Institutions have been offered the ability to invest in the underlying commodity in lieu of a commodity-based stock. Gold, silver and oil ETFs all have developed acceptable trading volumes.
Looking ahead, commodities have already gained status as a legitimate and competitive asset class, and the secular inflow of investment funds to commodity indices is becoming mature.
The fact that commodity ETFs are actively traded and are available alongside traditional equity-based ETFs suggests commodities will have to provide returns which are competitive in order to attract capital. Investors can just as easily buy a basket of technology or financial socks as they can buy an individual commodity ETF or basket of commodities via an ETF. There are a number of factors which will determine the future flow of money to commodity-based investments.
Among those that could result in a bear market for commodities are:
Long-only profits will be more difficult to achieve in the wake of a mature bull market in commodity indices and high commodity prices will also invite increased production;
The global economic expansion is at a potential inflect point, as US economic growth has slowed on the back of a recession in the housing sector, and China and India are working to tighten monetary policy in order to combat inflation;
The Bank of Japan has ended its ultra-easy monetary policy. Tightening monetary policy and troubles in the US housing sector raise the prospect of disinflation or at least the end of inflationary tailwinds;
The recent dislocation in the sub-prime mortgage market is not only a risk to global economic growth, but could also disrupt the low volatility environment which has permeated the capital markets over the past few years. The recent equity market decline saw financial shares among the worst performers in part due to their exposure to credit and a potential deleveraging of investment positions; and
The inflow of money into index funds has shifted the carry structure of the energy markets from backwardation to contango. The persistent contango structure has been a drag on returns, as illustrated by the 15% decline in the Goldman Sachs Commodity Index during 2006.
Conversely, other factors could push commodities back into bullish territory:
The sub-prime mortgage dislocation is a double-edged sword. Although it could cause volatility to return to the capital markets, it leaves the dollar vulnerable to a decline in the wake of a housing recession. A weak dollar would be a plus for precious metals and a reminder of the need for a store of value;
The Middle East will remain volatile by nature, and there are weather prognosticators who believe the current La Niña pattern could bolster Atlantic hurricane activity, putting energy supplies at risk;
Strategic reserve building is also becoming a theme as countries try to maintain supplies for reasons of politics and economic security. Countries like China are talking about using foreign exchange reserves to buy commodities;
There is strong movement toward alternative fuels like ethanol, benefiting both grains and sugar; and
China and India’s appetite for commodities is likely to remain large as both countries work toward modernisation and build infrastructure to satisfy their large populations.
While commodity indices have now earned a permanent carve-out in many institutional portfolios, they will have to compete more directly with traditional asset classes and capital market-based investment strategies – based principally on investment return.
Against a continued backdrop of low interest rates and moderate risk premiums, investor focus will continue to be driven by a search for yield. As the value proposition for commodity investment moderates relative to capital market-based investment, there is elevated risk of decreased demand in passive commodity-based vehicles. Despite the potential of a short-term setback, passive commodity-based investment vehicles should continue to present a worthwhile value proposition.
Hadrian Partners Ltd is a New York-based investment advisor specialising in hedge fund and commodity-based investing. Hadrian Partners provides investment management services to family offices, institutional investors and private foundations.