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Aon Retirement and Investment Blog

Sources of Return in Active Commodity Management

Commodities have fallen out of favour with investors in the last few years, but as some of the underlying supply-demand dynamics appear to have stabilized, it is worth reviewing how the asset class can be accessed, and the ways active managers can create value in what is often thought of as a pure beta proposition.
Why not just invest in the index?
The differences between commodity indices available to investors mean that making a choice of index is already an active decision. The Bloomberg Commodity Index (“BCOM”) and the S&P GSCI Index (“GSCI”) are the most tracked benchmarks by the industry. The BCOM is reasonably well balanced across different commodity sectors whilst the GSCI has a much higher weighting to energy, as shown below[1].

Once an index has been selected, accessing the asset class via passive funds or total return swaps will likely result in the lowest headline cost. But is this the most efficient way to invest in commodities? Probably not. There are a number of drawbacks in the way commodity indices are set-up, which are naturally captured by passive replication strategies. These very weaknesses are part of the opportunity set tapped by active managers, a concept best illustrated by looking at the components of return for a liquid commodity investment as outlined below.
Total return in commodities
In contrast to traditional assets classes, commodity spot prices cannot be traded within a liquid investment mandate, as these relate to the physical trading side of the commodity market. Both BCOM and GSCI gain exposure to the asset class by investing in commodity futures contracts, with a focus on the first delivery month due to its superior liquidity and closer track to spot prices.

The total return for a commodity index can be summarized as:

Sources of active returns
Active commodity managers have varying degrees of flexibility with regards to how they can add value to the three components of return.
Spot Return – Portfolio managers may generate a layer of alpha by using different weighting and rebalancing methodologies, and by investing in a different, often broader, set of commodity futures relative to the index. An active manager can also help add value by tactically over- or underweighting exposure to certain commodities based on fundamental or technical considerations. For example, disruptions in oil producing countries, unexpected weather patterns, and industrial actions in the mining industry, all have the potential to impact commodity prices, giving a skilled manager an opportunity to profit by tilting the allocation.
Roll yield – Active managers may add value by investing in different parts of the futures curve and in managing the timing of the roll. As a majority of commodity market structures are typically in contango (i.e. upward sloping curves with futures prices higher than spot prices), selling a contract approaching expiration and rolling the position to the following one generates a negative contribution[2]. Contango is usually stronger on the front-end of the curve creating a structural drag on index returns which compounds over time. Active managers have the ability to roll further out the curve where the risk/return trade-off may be more attractive.

Past performance is no guarantee of future results. Investments cannot be made directly in an index.

Collateral Yield – It is not unusual for unencumbered cash to stand in excess of 80% of a commodity fund’s assets. The main indices assume this cash to be invested in 90-day US T-bills, an approach that is followed by a number of active portfolio managers that don’t want to add elements of credit or interest rate risk to their portfolios. Other active managers offer versions of their strategies that invest the collateral, either passively or actively, in different segments of the fixed income space. In this regard, a popular option for investors looking to add to their inflation hedging strategies is that of investing the collateral in inflation linked bonds.
Enhancing portfolio diversification and adding to inflation protection solutions are two common uses of commodities. In these cases, investors often approach the space wanting to access the beta of the asset class in the most efficient way by focusing on minimizing the headline cost of their allocation.
We argue that, while still a sensible approach, investing in broad index replication strategies foregoes return opportunities that are available to active managers. These may come from taking advantage of the known structural inefficiencies of the indices or, similarly to other asset classes, by taking active views on the underlying commodity assets. Deviating from the index allocation also means adding sources of risk for the investment (for example, risk of loss/underperformance as well as tracking error relative to the benchmark), thus a thorough consideration of expected costs and benefits of both approaches is required.
Several investment options are available when it comes to liquid commodity investments, and here we briefly focused on low- and high-tracking error long-only funds. A broader discussion on the asset class may also involve considering solutions like long/short commodity managers, natural resources equities and enhanced indexing strategies.
Riccardo Lawi is a hedge fund researcher within the Liquid Alternatives manager research division of Aon Hewitt in London.
Click here for index descriptions.

[1] Market structures in backwardation (i.e. with futures prices being lower than spot prices) benefit from the opposite effect, although these situations are less common.
[2] BCOM and GSCI share many traits with regards to the constituents and the rebalancing rules, but differ significantly on the weighting methodologies. BCOM relies for the most part on liquidity considerations pertaining to the underlying futures contracts, also taking into account global production factors. GSCI’s weights are derived by looking exclusively at global production factors, which results in a heavier concentration in the energy sector.
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