Two pioneering academics make the case for commodity index investments
Commodities “couldn’t be hated more”, said the publicity for an investment conference in New York last month. The reason is simple: investors feel let down after a revolutionary attempt to invest in basic materials went horribly wrong.
Four years of negative returns for indices tracking futures, with a fifth under way, have undermined the idea that leaving part of one’s portfolio in a basket of oil, natural gas, soyabeans, copper and other commodities was prudent. “There’s zero interest right now from the institutional space,” says Lawrence Loughlin of Drobny Capital, which hosted the conference.
But that widespread disillusionment is not shared by a pair of academics who a decade ago prompted institutions from pension funds to asset managers to pour billions of dollars into commodity futures. This deep and liquid market had until then been largely untouched by the big investment institutions.
The duo, Gary Gorton and K Geert Rouwenhorst, both of Yale School of Management, have published fresh research supporting their original, controversial conclusions. The two central issues could scarcely be more critical to both investors and regulators.
First, did investors who waded into commodities after the publication of the academics’ first paper in 2004 wind up distorting the marketplace? Second, after years of poor returns, does commodity index investing still make sense?
The academics’ original research found that a futures index could offer similar returns to equities but moved out of step with either stocks or bonds. These low correlations were critically important to fund managers as they offered the prospect that commodities could continue to offer some return even if stocks turned down. There was an added sweetener: commodities protected against inflation better than stocks or bonds.
The past 10 years, they contend, have not significantly changed this picture. “I think you should always have exposure to commodity futures if you’re a large investor,” says Prof Gorton.
Institutions responded enthusiastically to the original paper, entitled Facts and Fantasies about Commodity Futures. The number of commodity futures contracts outstanding nearly doubled between 2004 and 2007.
Their big commodities experiment has so far been a disaster, however.
Commodity prices crashed with equities following the financial crisis and traded tightly in line with the stock market over the nervous years that followed, providing no diversification. When they finally parted company they inflicted more pain as commodities tumbled while stocks roared ahead. The Bloomberg Commodity Index has lost 37 per cent on a total return basis since early 2011.
“People feel they’ve been conned a bit. I think the enthusiasm for commodities is pretty limited at this point in time,” says Colin Robertson, a London-based former head of asset allocation for an investment consultancy.
Worse, politicians blamed the entrance of the new investors for the market’s problems, saying the influx had “financialised” commodities by distorting prices that should be shaped by forces of supply and demand. Implicit in their criticism was that bullish index investments were pushing prices up, hurting consumers.
US senator Joe Lieberman proposed that index funds and institutions be barred from holding commodity futures, saying: “We may need to limit the opportunity people have to maximise their profits because a lot of the rest of us are paying through the nose, including some who can’t afford it.”
The UN Conference on Trade and Development attacked financialisation and said index traders “can significantly influence prices and create speculative bubbles, with extremely detrimental effects on normal trading activities and market efficiency”.
Some academic research bore this out. Ke Tang of Tsinghua University and Wei Xiong of Princeton University found that financialisation made ostensibly different commodities such as grains and oil more closely correlated after 2004. The trend was “related to large inflows of investment capital to commodity index securities during this period”, Prof Wei wrote.
But Profs Gorton and Rouwenhorst are holding their ground. The new paper — Facts and Fantasies about Commodity Futures Ten Years Later — argues that the impact of financialisation was marginal and that their decade-old recommendation for institutions to hold commodities remains good. They co-authored the paper with Geetesh Bhardwaj, a researcher at SummerHaven, a $1.4bn commodity fund manager where Prof Rouwenhorst is also a partner.
The paper was published after the authors grew frustrated with the mounting pile of studies on financialisation. “We wanted to know whether any of this had any truth to it,” says Prof Gorton. “We can smell bad research from a long way off.”
The new paper, which has not yet been peer reviewed, acknowledges that after 2005 commodities did move more closely in line with other asset classes and with each other, especially during the financial crisis. The correlation between commodities and stocks — negative before — became strongly positive after 2005, which was just when asset owners most needed some protection from the crash in equities. This was disastrous for risk managers; institutions’ commodity investments had failed to spread or reduce their risk as intended.
Energy, metals, grains and soft commodities such as cotton and sugar also showed stronger correlations with indices after 2005, the authors show.
The new paper illustrates that these correlations have spiked before, notably during the early 1980s and the 1960s, long before financialisation became an issue. Lately, correlations have returned almost to zero. This is true even though index investors still make up 24 per cent of the open interest in major commodities, according to Barclays.
Prof Rouwenhorst says: “Why did correlations suddenly go down to pre-crisis levels? Financialisation suggests a permanent condition.”
Instead, he and Prof Gorton argue that the return to low correlations suggests commodities are once more primarily driven by supply and demand in their own markets, and not by fears in the stock and bond markets. Therefore, they do offer some hedge or diversification for big asset managers.
Further, they report data showing that fund managers and speculators constitute about half of the commodity futures market, virtually unchanged from a decade ago. Even though the total number of outstanding futures contracts has doubled, positions held by commercial companies using the futures market to hedge their risks have only risen in line with demand from financial investors.
“The markets have been invaded by a large colony of new speculators,” says Prof Rouwenhorst. But “the markets have grown proportionately”.
If this answers the charge that their recommendation to invest in commodities distorted the market, their suggestion that they are a wise investment still has to overcome huge scepticism.
Commodity prices often trace long arcs as farmers, miners and drillers take years to adjust supply in response to shifts in demand. Economist José Antonio Ocampo of Columbia University found the typical commodities cycle lasts two to four decades.
In 2004, commodities investing was fuelled by excitement over China. As its economy expanded, the country’s oil consumption rose by half between 2004 and 2011. Its soyabean imports doubled.
The appeal of the professors’ original 2004 paper was that it did not rely on anticipating commodity price cycles. Instead, it raised hopes that investors could make money by keeping a portion of their portfolio in commodities year after year, regardless of fleeting variables such as droughts that kill crops or wars that bottle up oil exports. But with China cooling and markets such as oil amply supplied, investors now view commodities “as opportunistic short-term investments” rather than anything more long-term, say Barclays.
Playing the long game
The scholars took a long view, examining the performance of a custom-built index of commodity futures contracts such as zinc and corn ranging from 1959 to 2004. That research was sponsored by AIG Financial Products, which used it to help sell derivatives contracts that allowed investors to buy index-linked bundles of commodities — and would later become notorious for the huge credit default swap bets that forced the US government to bail out its parent company in 2008.
Profs Gorton and Rouwenhorst established that commodity investors made money from collecting a “risk premium”, essentially a fee paid by producers for the service of allowing them to hedge the future value of a barrel of oil or bushel of wheat. They concluded that, over time, the risk premium in commodities was about equal to that in stocks and better than the premium in bonds — both of which currently look very expensive by historical standards.
Their new paper indicates that the commodities risk premium has fallen to 3.7 per cent in the past decade, down about 1.5 percentage points from its historical average. But this is because the Treasury bonds that investors often hold as collateral for their futures, are currently generating historically low returns. The critical point, they say, is that even now there is still a premium.
Some agree. Olav Houben, managing director of commodities at APG, the Dutch pension asset manager with $12bn invested in the sector, says: “As for expected returns, the story has been less compelling than in the past. But still, the diversification and inflation hedge from commodities are important to our clients.”
But evidence of commodities’ unpopularity is easy to find. Alasdair Macdonald, head of advisory portfolio management in the UK for Towers Watson, an influential investment consultant, says he is “biased towards only holding commodity futures when you think their price will go up”.
The last year that investors pumped net cash into commodity index swaps was 2010, according to Barclays. A trickle of outflows became a torrent in 2014, when investors yanked $24.2bn reducing the value of commodity assets under management to $67bn from a pre-criss high of more than $150bn.
The $36.4bn Harvard University endowment this year cut its target portfolio for commodities to zero. It was as high as 8 per cent in 2008. “We now consider this area less valuable as a method of diversification,” it explains.
But the academics remain unrepentant. “The fact that the past has been negative doesn’t necessarily mean you should suddenly leave. That’s just too late, ” says Prof Gorton. “The question is what can you do about the future.”