(John Kemp is a Reuters market analyst. The views expressed are his own)
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 themselves.
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 contributions.
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 investor.
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)
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