Swedroe: Financialization And Commodities

August 10, 2015

Slightly more than a decade ago, several studies were published raising the possibility that an allocation to commodities (in the shape of fully collateralized futures) could improve the efficiency of a portfolio due to the diversification benefit (the low to negative correlation of commodities to both stocks and nominal bonds) provided through including this asset class.

The publication of these papers was closely followed by a dramatic increase in the demand for commodity investments, and Wall Street responded by creating a host of new alternative investment vehicles. Between 2004 and 2008 alone, it’s estimated that at least $100 billion moved into commodity futures. This increase in investor demand has led to what’s been called the “financialization” of commodities markets. As is always the case, an increase in demand impacts prices and expected returns.

Since the financialization of commodity markets is a relatively new phenomenon, its effects are still being debated within academic communities, and we don’t have much data to analyze.

A related question, however, is this: Even if it were possible to quantify the changes that financialization has brought, are they temporary? Or have they, in fact, resulted in a permanent change to the structure of the commodity markets?

Adam Zaremba—author of the study “Is Financialization Killing Commodity Investments?”, which appears in the Summer 2015 issue of The Journal of Alternative Investments—investigated, from the perspective of a U.S. investor, the impact of financialization on the roll returns of futures contracts.

This is an important issue, as roll returns are one of the three key components of returns from commodity futures. Before digging into the study, let’s take a brief look at the different ways in which it’s possible to invest in commodities.

Investing In Commodities

Exposure to commodities can be obtained by:

  • Direct investment in physical commodities. With the exception of precious metals (such as gold), investing in physical commodities is complicated. It can involve storage, transportation and insurance. Thus, it’s generally not a practical option for most individual investors.
  • Investment in commodity-related stocks. Unfortunately, the evidence demonstrates that commodity-related stocks are more highly correlated with stocks in general than with commodities themselves. They also tend to produce lower-than-equity returns.
  • Fully collateralized commodity futures. Not only have returns to fully collateralized commodity futures exhibited low to negative correlation with stocks and bonds, but (unlike with stocks) their returns were positively correlated with inflation and thus provide a hedge against that risk.

We will now undertake a closer look at the sources of returns to collateralized commodity futures.

Sources of Returns To Fully Collateralized Commodity Futures

The three key sources of returns to fully collateralized commodities futures are:

  • Change in spot rates. In real terms, returns from changes in the spot rate have been about zero.
  • Return on the collateral. Returns on collateral obviously depend on the term and quality of the collateral being utilized.
  • Roll yield. Roll yield is the return from the passage of time (carry). If markets are in backwardation (where futures prices are cheaper than spot prices), then a premium is earned with passing time. If, however, markets are in contango (where futures prices are more expensive than spot prices), a negative premium is realized with passing time.

The research on commodities has also identified a fourth source: a diversification return. This is when the return on the portfolio is higher than the weighted average return of the components when rebalancing the components occurs.

Zaremba’s study focused on two major issues. The first involved whether the financialization of commodities has impacted roll returns. The second was that, if this financialization had a negative impact, did it call into question the efficiency of including an allocation to commodities in a portfolio, either as a portfolio enhancer or a stand-alone investment?

His research was divided into two stages. The first was to investigate whether financialization had impacted roll returns. The second was to investigate any impact that a change in roll returns had on the question of portfolio efficiency.

The study, which covered the period 1990 through 2012, used the J.P. Morgan Commodity Curve Index (JPMCCI) as a proxy for the return on commodities as an asset class.

Financialization’s Impact
Zaremba’s analysis of the data led him to estimate—and he emphasized that this should only be treated as an estimate—that financialization had led to an expected roll return of about 0.38 percent per month (about 4.5 percent per year) lower than the average for the full period.

This, in turn, led him to conclude that while including commodities in a portfolio pre-financialization may have been efficient, the decrease in the roll return now calls that assumption into question.

Zaremba writes: “In other words, as a result of the process of commodity markets’ financialization, the benefits of commodity investments in terms of portfolio may not be valid anymore.” He did add the following: “They still may turn attractive if roll yields enter their positive territory anew.”

Before you draw too strong a conclusion of your own, consider that, while the roll return did turn sharply negative for a number of years following financialization, the roll yield did turn positive again at the end of 2013 and remained there into 2014 for some commodities (before turning negative again).

Roll yields have always fluctuated, and it’s possible that we simply have gone through a cycle where they had been highly negative. Zaremba cited research that found roll yields go through cycles in which they are usually lower during an investment phase and usually higher during an exploitation phase (a phase he says that we had entered in 2011).

Commodities And A Tactical Approach
This finding also raises the question of whether a tactical approach (one that seeks to maximize roll returns) to commodities might add value. There are several mutual funds and ETFs that seek to manage the roll return, targeting the part of the curve where the roll costs are the lowest. Others go long the commodities with the lowest roll costs and short the commodities with the highest roll costs.

A benefit of long/short funds is that they avoid the risk of crashes in commodity prices (such as the crash that occurred in 2008), and that improves their diversification benefit relative to stocks. However, long/short funds sacrifice the ability to provide a hedge for inflation risks.

Before you make any decisions on commodities, keep in mind that investors are notorious return chasers. They tend to buy what has done well recently and sell what has done poorly. The financialization of commodities, which likely led to higher roll costs, resulted in the poor returns investors have experienced. Those poor returns are now causing an exit by those same investors.

If this trend continues, the problem caused by the increased demand would solve itself, restoring the efficiency of including an allocation to commodities. It appeared that was the case in late 2013 and early 2014, when roll returns turned positive (temporarily, as it turns out).

Unfortunately, and as usual, my crystal ball remains cloudy. Thus, as is always the case when it comes to investing, we are forced to make decisions in the presence of uncertainty.

A Fund From AQR
Finally, an interesting alternative fund to consider, although only about 10 percent of its assets are invested in the asset class of commodities (in long/short strategies), is the relatively new fund from AQR, its Style Premia Alternative Fund (QSPIX). It was launched at the end of October 2013.

The fund seeks to provide long-term, positive expected returns with low correlation to traditional asset classes by investing long and short in a broad spectrum of asset classes and markets.

It uses market-neutral, long/short strategies across six asset groups and four distinct investment styles. The six different asset groups are: stocks of major developed markets, country indices, bond futures, interest rate futures, currencies and commodities. The four investment styles are value, momentum (which should not be confused with trend-following, because momentum is a relative measure while trend is an absolute measure), carry and defensive.

Commodities are invested across the three styles of momentum, carry and value. In 2014, the fund returned 11.3 percent, and through July 28, 2015, it had gained 0.3 percent.

It’s important to note that, while this fund has higher expected returns than an investment in commodities and provides some other diversification benefits, it wouldn’t provide the hedge against unexpected inflation that a fully collateralized commodity futures allocation would.

And finally, in the interest of full disclosure, my firm, Buckingham, recommends AQR funds in constructing client portfolios. I have a significant investment in the fund.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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