(John Kemp is a Reuters market analyst. The views expressed are
By John Kemp
LONDON, April 15 The status of commodities as a
distinct asset class is under threat following another lousy
start to the year for investors.
Total returns on the two major commodity indices, the
Standard and Poor's Goldman Sachs Commodity Index
and the Dow Jones-UBS Commodity Index, show losses of
4.4 percent and 3.7 percent respectively so far this year, while
an investment in the S&P 500 equity index is up 12
percent, including dividends.
Both major commodity indices were flat in 2012, with
investors missing out on a 16 percent return on equities.
With the exception of the bull market in 2007-2008,
commodities have generally underperformed equities since 1989 (link.reuters.com/baf47t).
Investors seem set to conclude all the money to be made in
commodities is due to the skill of asset managers in market
timing, rather than inherent in the commodity derivatives
Rather than a distinct asset class, commodity funds are best
seen as a species of hedge fund.
FACTS AND FANTASIES REASSESSED
The perception that commodities are an "asset class" dates
from the early 2000s.
"Commodity futures have historically offered the same return
... as equities," Gary Gorton and Geert Rouwenhorst wrote in
their famous paper "Facts and Fantasies about Commodity Futures"
published in 2004, which helped popularise commodity investing
among pension funds and other institutional investors.
Gorton and Rouwenhorst based their conclusion on backtested
returns from a diversified and equally-weighted basket of
commodity futures, fully collateralised by U.S. Treasury notes,
between 1959 and 2004.
Crucially, while they found the risk premium was the same as
equities, the authors argued commodity futures returns were
negatively correlated with equity returns and bond returns, but
positively correlated with inflation, unexpected inflation and
changes in expected inflation (www.nber.org/papers/w10595).
These findings helped convince investors commodities should
be treated as a distinct asset class that could improve
risk-adjusted returns in a diversified portfolio and were
especially valuable in providing protection against inflation.
Following several years of severe underperformance by all
the major commodity indices, all elements of the theory are now
ripe for reassessment.
Returns on commodities futures have underperformed equities
by a significant margin for 25 years, despite two major equity
bear markets in 2000-2003 and again in 2007-2009.
Commodities continue to offer diversification, but the wrong
sort, into an asset that offers more volatility than equities
but without the returns.
Since 2011, commodity investors have missed out on the
reflation-trade driven by record low interest rates and
central-bank balance-sheet expansion. If the Federal Reserve and
the other major central banks are inflating a new bubble in
bonds, equities and other financial assets, it has by-passed
commodity markets completely.
COMMODITIES AND HEDGE FUNDS
The first generation of commodity indices were avowedly
marketed as index products designed to enable investors
passively to harvest the risk premium or "beta" Gorton and
Rouwenhorst described in their paper.
As returns have persistently disappointed in the years after
the bull market peaked in 2008, new indices have been launched
with "enhanced" and "dynamic" features designed to generate more
"alpha" like returns similar to a hedge fund.
The line between passive indexing and active hedge fund
style management has become increasingly blurred. Most indexing
strategies now emphasise a blend of alpha and beta
But the continued underperformance of the basic indices like
the GSCI and DJ-UBS suggests the contribution from the beta
element may be zero or negative (reflecting the cost of
storage). If beta is zero, then all the returns to investing in
commodity futures come from the alpha element.
Commodity funds should be regarded as a species of hedge
fund, with returns entirely due to the skill of the portfolio
manager in timing commodity price cycles, rather than as a
distinct asset class with inherent returns, like equities, bonds
and real estate.
Some investors have made extraordinary returns from
commodities. The world's top commodity trading houses have
earned nearly $250 billion over the last decade, according to an
analysis published in the Financial Times ("Commodity traders'
$250 billion harvest" April 14).
Most of the revenues have come from buying and selling
physical commodities, rather than investing in derivatives.
Nonetheless, the trading houses can be considered a species of
In every case, however, returns have been generated by
actively trading based on knowledge of the fundamentals
(physical supply/demand/inventories) and an understanding of
market psychology (momentum and herding), timing purchases and
sales, rather than employing a passive buy and hold strategy to
harvest inherent returns.
If they want to enjoy similar success, investors need to
approach commodities from the perspective of a hedge fund
product rather than an index.
(Editing by Keiron Henderson)