The Alpha and Beta of Commodities Investing
At this year’s Middle East Investment Conference, Russell Read, CFA, had a tough task. The chief investment officer and deputy chief executive of the Gulf Investment Corporation (GIC) was called on to explain the complex world of commodities investing and its role in generating portfolio returns. But as the man who helped introduce the first commodity-based mutual find in 1997, attendees couldn’t have asked for a more seasoned professional to explain the role of these often impenetrable instruments.
Commodities may be tough to understand, but they are one of the oldest traded financial instruments. The Dojima Rice Exchange dates to 1730. The Chicago Mercantile Exchange Board was founded in 1858. Most students of finance are in fact reasonably aware of the two main tools for trading commodities: futures contracts, which are exchange traded with minimal counterparty risk, and forward contracts, which are traded over the counter and involve counterparty risk specific to each instrument.
Commodity trading is used for physical hedging, financial hedging, repositioning, and speculating by specialty investors, such as hedge funds. What trips up many professionals is the leveraged nature of the trading, which requires marked-to-market margin levels. This scares away many institutional investors because trading futures and forwards contracts is mostly tactical. Read emphasized that successful speculators need special skills that are not commonly found in stock and bond portfolio managers.
Read put forward the argument that commodity futures and forwards contracts cannot be considered an asset class because they are not natural diversifiers to stocks and bonds for institutional investors. In addition, he contended, the primary focus on hedging and repositioning does not lend itself to either market (beta) returns or the potential for above-market results (alpha). Still, he acknowledged that if commodities are held in an unleveraged and diversified way, they can aspire to be a separate asset class.
Should investors gain exposure to commodities via indices? S&P GSCI and Dow Jones AIG are the major reference indices. The main reasons to invest in them, Read said, are diversification, long-term return potential, and inflation protection. However, inflation protection from commodities is mostly limited to energy exposure. The introduction of energy commodities into a typical portfolio split 60/40 between stocks and bonds improves returns while reducing volatility, thanks to low correlations. However, index exposure to commodities may not appeal to many investors because it is an amalgam of rolling futures contracts and thus tends to deliver beta rather than alpha generation.
So how can investors position themselves for alpha in the commodities space? One way is to buy or sell physical and financial commodities where supply and demand are “out of balance” due to various reasons, Read said. This is what most active managers and hedge funds do. Of course, traditional managers are often bound by relative returns to benchmarks. They cannot short securities, utilize derivatives, or own leveraged exposures. In contrast, alpha managers are driven by absolute returns. Still, the alpha business is getting highly competitive thanks to less liquid markets, more complex instruments, and innovators exploiting new opportunities for returns.
On balance, though, commodity strategies do have a major and multidimensional role to play in a diversified portfolio — especially for investors in the MENA region, where management of commodity risk remains less developed. Furthermore, the strong relationship between energy prices and MENA stock price appreciation (and economic growth generally) makes commodities a great additional source of returns and an important hedging and diversification tool.