Commodity investment goes back to fundamentals

The past year has not been a good one for commodity investment. Passive commodity indexes have delivered disappointing returns, while a number of high-profile commodity hedge funds have been forced to close. What is the outlook for investor interest in commodities? Gillian Carr reports

It's been a tough year for commodity investment. The broad gains in commodity markets seen during recent years – dubbed the commodity 'super cycle' – seem to have come to an end, and investors have been left holding the bag. Strategies that produced results during the boom years have increasingly failed to find the same returns, and market participants say the mood of investors towards commodities has noticeably changed. Funds have been pulled from many passive commodity investment products, such as exchange-traded funds and commodity-linked notes, while actively managed commodity funds have been beset by redemptions and high-profile closures.

In many ways, it's a reversal of fortunes for commodity investment. While commodities took a dive during the 2008 financial crisis, they soon recovered, in what analysts portray as a general rise across the commodity spectrum, from energy to agriculture. Demand from developed economies was propped up by the surging needs of emerging markets – most notably, China. From the beginning of 2009 to April 29, 2011, the S&P GCSI shot up from 359.02 to 758.79, according to New York-based S&P Dow Jones Indices. Likewise, the Dow Jones-UBS Commodity Index ballooned from a level of 117.24 to 175.42 (see figure 1 below).

Such gains attracted a wave of interest from both institutional and retail investors disappointed with the scant returns available in other markets, such as government bonds. Commodity assets under management (AUM) rose from $160 billion at the end of 2008 to $428 billion by the end of 2012, according to data from Barclays. "Seven or eight years ago, investors were very bullish and they could make money by simply buying a basket of commodities," says Alexandre Cosquer, Paris-based head of commodity investor business at Société Générale Corporate and Investment Banking (SG CIB).

Steadily climbing markets were particularly favourable for passive index strategies, which saw a heavy gain in AUM. "The past five years saw a lot of institutional investors and retail investors get involved in commodities, often through passive commodity futures index strategies, and there was a lot of money flowing into them," says Jon Ruff, San Francisco-based portfolio manager and director of research at asset manager AllianceBernstein.

In the wake of the crisis, fundamental moves in specific commodities became overtaken by broader macroeconomic factors, say analysts. Central banks and governments across the globe poured money into financial markets through both quantitative easing and fiscal stimulus, with much of it ending up in commodities. Concerns about tail risk prompted the emergence of a 'risk-on/risk-off' attitude among investors, which saw money flow in and out of commodities depending on market nerves. As a result, commodities began to show a strong correlation with other markets, while individual commodities moved in sync with each other.

"The big driver of all asset prices since 2008 has been macro factors and up until the third quarter last year, it was risk-on/risk-off trading and commodities were just swept along with that," says Kevin Norrish, London-based head of commodity research at Barclays.

During the period from 2009–11, the average 90-day correlation between the S&P GSCI and the S&P 500 indexes topped 50%, according to Norrish. In mid-2012, average 90-day correlation between the two benchmarks reached a high of 74%, he adds.

"Post-crisis, quantitative easing created a lot of liquidity and that liquidity went into risk assets. Therefore, you saw correlations between commodities and equities increase significantly from 2010 onwards. A lot of the commodities – especially those in industrial metals and to some degree, the energy market – ended up being driven by quantitative easing," says Jeremy Baker, Zürich-based senior commodity strategist at Harcourt Alternative Investing, an independent investment boutique.

The increased correlation of commodities with broader macroeconomic trends made life tougher for specialised commodity investors, says Baker. "It made the environment more challenging for investors, because you can be very right on the fundamentals, but it was also about understanding the macro story," he says.

Nonetheless, some investors benefited during that macro-driven period, according to Kamal Naqvi, London-based head of commodity sales for Europe, the Middle East and Africa at Credit Suisse. "It was easier to make money than today, because you knew commodities would suffer from the crisis, so you could be short with some confidence. Likewise, [you could be] long when we saw massive stimulus from China and other countries, so we did see some impressive positive returns from active managers," he says.

Disappointing returns

More recently, disappointing returns have curtailed investor enthusiasm for commodities. At the market close on October 30, 2013, the S&P GSCI stood at 627.21 – a level well below the figure of 758.79 seen on April 29, 2011. Similarly, the Dow Jones-UBS Commodity Index closed at 126.63 on October 30, 2013, down from 175.42 on April 29, 2011, according to S&P Dow Jones Indices.

These underwhelming returns have been damaging not just for passive investors, but also for actively managed hedge funds. Back in 2010, the Newedge Commodity Trading Strategies sub-index, which tracks the performance of alternative investment managers using strategies involving derivatives and physical commodities, registered a healthy return of 9.23%. For 2011 and 2012, the equivalent figures were –1.56% and –2.84%, respectively.

A number of high-profile hedge fund closures have ensued, including London-based commodity fund Clive Capital, which announced its intention to close in a letter to investors on September 20. In the letter, the fund said it was shutting down thanks to "limited suitable opportunities... to enable us to utilise our directional, long volatility approach to generate the strong returns of the past". Clive Capital did not respond to requests for comment from Energy Risk.

Clive Capital has not been the only victim. Other reported casualties of the current market environment include London-based BlueGold Capital and New York based Arbalet Capital, while several other prominent commodity funds are said to have seen significant declines in their AUM. Representatives of BlueGold and Arbalet did not respond to requests for comment.

Naqvi notes that many hedge funds failed to thrive in the risk-on/risk-off environment seen immediately after the financial crisis, so their more recent underperformance has been particularly gruelling. "This has encouraged a fear of the asset class having structurally changed and that there is now only a mirage of commodity alpha opportunities."

Market participants believe many hedge funds have been caught off guard by the failure of different commodity markets to rise in tandem with each other. "Although it is not clear why some commodities funds have underperformed, perhaps it has to do with commodities funds relying on continuing trends or broad capital inflows," says Bill Perkins, managing partner of Skylar Capital, a Houston-based natural gas hedge fund.

Credit Suisse's Naqvi says many fund managers continued to place sizeable directional bets on commodities, despite broader changes in the market environment. Such strategies have failed to pay off, he notes. "A lot of managers have been active mainly over the past decade and were schooled in the world of being heavy directional and long volatility. Those two have probably been the worst trading strategies since that environment has changed."

Opportunities

There may yet be compelling opportunities for active managers of commodities, though. As of October 22, the 90-day average correlation between the S&P GSCI and the S&P 500 stood at just 5%, according to Barclays. For the Dow Jones-UBS Commodity Index, 90-day average correlation with the S&P 500 was even lower, at –2%. Correlation between different commodity markets has also retreated, say analysts, with a significant divergence in the performance of individual commodities.

"It's a very big theme that fundamentals are driving commodities again," says SG CIB's Cosquer. "You need to look at fundamentals and you need to look at each individual commodity, because the fundamentals driving crude oil will be different from the ones driving copper, for example."

Consequently, firms say passive investors need to be prepared for lower returns, as commodity index funds can no longer simply hang onto the coat-tails of rising markets. "[Commodities] are one of the very few asset classes that haven't had a very strong year-to-date performance," notes Tim Edwards, London-based director of index investment strategy at S&P Dow Jones Indices.

That is potentially a good omen for more specialised commodity hedge funds, which aim to benefit from fundamentally driven opportunities in specific markets. Skylar, for example, hopes to profit from natural gas basis trading – in other words, trading the spread between natural gas prices at different delivery locations throughout the US. Rather than being associated with macro factors, volatility in such spreads is more closely linked to physical supply and demand variables, such as pipeline constraints and demand for residential heating. "Natural gas continues to offer a low-correlation opportunity, because it is impacted by fewer global macro factors and more by local and regional balances," explains Perkins. "As a US-focused natural gas trader, we have the benefit of trading a relatively insulated market that is less subject to capital flows and more impacted by supply and demand fundamentals."

As well as funds specialising in individual commodities, the trend is also positive for competent active managers of broad commodity portfolios, says one Connecticut-based commodity hedge fund manager. "More of an alpha approach is better right now, when you can arbitrage out some macro risk by having a portfolio of longs in things you believe are tight and shorts in things you think are oversupplied, and have a reasonable chance for them both to make money," he says. "In a low-correlation environment, that's actually pretty ideal."

A question of appetite

But how much appetite do investors still have for commodities? Some market participants, including Harcourt's Baker, argue that demand for commodity exposure among investors remains strong. Although they acknowledge the recent decrease in commodity AUM, they argue the picture is more complicated once individual commodity sectors are taken into account.

"When you talk about money flowing out of commodities, it's primarily in precious metals. When you talk about major flows into commodities, the reality was most of that money was in gold and precious metals and what we're seeing now is a reversion of that," says Baker. "Yes, there are some outflows from broader commodity indexes themselves, but the majority of the flow has been in precious metals," he says.

From $428 billion at the end of 2012, commodity AUM had fallen to $363 million by the end of August this year, according to Barclays. The vast majority of that decline was recorded in precious metals, which dropped from $200 billion to $137 billion. In contrast, energy AUM grew from $125 billion to $128 billion during the same period, according to the bank.

Nonetheless, some investors will remain sceptical, says AllianceBernstein's Ruff. "A lot of investors feel burned by commodities in whatever form they had invested in the past couple of years, from strategies such as commodity trading advisors to managed futures. They have not had a good run and the passive indexes haven't done well either."