ANALYSIS

Commodities demand a fundamentally active approach

Investing in commodities via passive strategies presents some unique challenges due in part to the structure of futures contracts. GE Asset Management which has been managing commodities for the GE pension fund for five years, and opened that expertise to external clients last year, believes a better approach is active management using fundamentals.

Commodities is a bit of a darling in the institutional investment world at the moment. Last year the total assets under management reached a high of $376 billion, according to Barclays Capital, and demand for the asset class continues.

As with other investments the decision about whether to employ active or passive strategies is part of the analysis of the sector, but with commodities there are a number of unique questions to be asked if investors wish to capture the diversification and inflation-hedge benefits of commodities.

Nicholas Koutsoftas, senior vice president and portfolio manager, commodities at GE Asset Management says a commodity acts differently to an equity.

“It is more reflective of the current demand and supply, a spot asset, so it has good diversification benefits for the overall portfolio for the same amount of return,” he says.

One of the sources of returns for commodities is roll yield – which is the return generated by rolling a futures contract from month to month as that contract converges on the spot price. Unlike stocks or bonds, futures contracts expire on a monthly or quarterly basis.

Benjamin Ross, vice president equity trading and commodities portfolio manager at GE Asset Management, says negative roll yield occurs as a result of contangoed markets and has become a significant drawback for passive commodity index strategies in recent years.

“You can mitigate it by positioning yourself on the curve,” he says.

The other sources of returns from investing in commodities are: the spot return, or the change in market price of the physical commodity; and the collateral yield, or the interest made on the cash yield in the account.

GE Asset Management believes by combining fundamental views with the flexibility of an active approach, an investment team can strategically set individual commodity weights.

Active managers can make investment decisions market by market and take short positions in a commodity market where their analysis predicts a low likelihood of unexpected price increases.

Koutsoftas says their approach employs the ability to short but also makes sure beta is preserved.

“In doing this we get the risk diversification benefits but also have the flexibility to gain alpha. Active management allows us to employ fundamentals to assess commodities, typically commodities are more quant,” he says.

By allowing shorting, Ross says the opportunity set is expanded.

“If you are long only, you’re limited to how many investments you can make, when you introduce spreads it increase opportunities by hundreds,” he says.

The fund remains fully invested on a net basis, so if there is a short then there is a corresponding long.

In addition to taking advantage of the shape of the forward curve in an attempt to capture the optimal roll yield, Koutsoftas and Ross argue that active managers can also employ spread trades in an effort to exploit relative fundamental dislocations between commodities, capture producer margins, and benefit from an expected shift in the curve structure.

For example at the moment the GE portfolio, which manages about $425 million, has significant under- and overweights in sectors and individual commodities.

“We are overweight agriculture as a sector, and underweight base metals. And at the individual commodity level we see corn as favourable based on a simple demand and supply equation, there are tight inventories versus strong demand,” Koutsoftas says. “We spend a lot of time on fundamental research to make those decisions.”

Using fundamentals also allows the portfolio managers to analyse investments in the context of broader trends, such as participating in the rapid industrialisation of emerging economies, which it sees as a new long-term secular bull market for physical commodities.

“Coffee, cotton, and coca also have tight stocks to use (fundamentals), with demand increasing because of the emerging markets story,” Koutsoftas says.

The choice of index is also a consideration with commodities, with the most popular, the S&P Goldman Sachs Commodities Index quite different in composition to the Dow Jones UBS index.

GE chooses to benchmark against the DJ UBS, which represents 19 commodities with weights based on liquidity (two thirds) and world production values (one third).

The GE fund invests in about 25 to 30 commodities in its portfolio, but might hold oil for example in five different positions

Excess return since inception is 345 basis points to the end of March.

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