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Commodity Indexing: Is this The Next Important Trend?
Innovator in alternative investment products
by Victor Sperandeo
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Will commodities be the preferred risk management tool as well as a source of returns?
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Understanding the source of commodities returns
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How correlated are the components of a commodity index?
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Second and Third Generation commodity indexes: Beyond long only
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Analyzing the value of commodities in a portfolio allocation
Analyzing the value of commodities in a portfolio allocation
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60% Stocks40% Bonds
55% Stocks35% Bonds10% Commodities
50% Stocks30% Bonds20% Commodities
45% Stocks25% Bonds30% Commodities
7% 8% 9% 10% 11% 12%
11.7%
11.6%
11.5%
11.4%
11.3%
11.2%
11.0%
Annu
aliz
ed R
etur
n
Annualized Standard Deviation
Stocks: S&P 500 Index, Bonds: Lehman Aggregate Bond Index, Commodities: GSCI
Source; Alpha Financial Technologies, LLC.
Analyzing the value of commodities in a portfolio allocation
Source; Goldman Sachs.Correlations between quarterly returns of the S&P GSCITM
in local currency and the financial asset. For bonds: 10y swap rates converted into total returns of the respective country in local currency. For Equity: S&P500 Total Return Index, Toronto 300TR, Nikkei 225, CAC 40, DAX, Amsterdam Stock Exchange
Index (AMS), SBC Index & Zurich Stock Exchange Index (SMI), FTSE -
UK all share.
Negative Correlation
S&P GSCITM
Correlation with Global Financial Assets Dec 1987 –
Sep 2007 Quarterly Correlations
Analyzing the value of commodities in a portfolio allocation
-2.0%
-19.7%
-17.6%
-15.5%
-10.8%
-20.0%
5.1%
16.6%
5.2%
-10.0%
-25.0% -20.0% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0%
GSCITR
Bonds
Cash
NAREIT Real Estate
World Equity
Australian Equities
Canadian Equities (TSE)
Small Cap Stocks
S&P 500
60/40 Portfolio
Commodities Perform Best When the Financial Portfolio Performs Worst
1970-Oct 2007
Source; Goldman Sachs.1. Unless otherwise specified, underlying data begins in January
1970 Australian Equities data starts in January 1971, World Equity data in December 1973 and NAREIT data in December 1972
Will Commodities be the preferred Risk Management Tool as well as a Source of Returns
55% S&P 50035% Lehman Agg
1986-2006 10% GSCI S&P 500 Lehman Agg Bond GSCI TR
Compound Annual 11.54% 12.95% 8.33% 9.47%Annualized STD 8.78% 14.88% 4.35% 18.49%Sharpe Ratio 0.74 0.53 0.79 0.24Maximum Drawdown -19.41% -44.73% -5.15% -48.26%
Annual Stats
Commodities are an Under Recognized Source of Returns
Commodities SHOULD BE
the preferred Risk Management Tool
Commodities are significantly negatively correlated to stocks, bonds & real estate►This implies that portfolio volatility can be significantly reduced by allocating to commodities
Commodities provide a hedge against rising inflation
Commodities perform Best when other asset classes perform Worst►commodities have the largest impact on a portfolio when the other asset classes experience their
worst returns
Commodities are the most directly tied to “current”
Economic conditions►The expected returns of Financial assets tend to fall in high levels of economic activity while
commodities tend to perform best in periods of high economic activity
Source; Alpha Financial Technologies, LLC.
Understanding the Source of commodity Returns
Commodity Index returns are derived from 5 sources:►Excess Return►Collateral Yield►Roll Return (risk transfer premium)►Rebalancing►Diversification
Excess Return:●
Excess return is the change in price of a commodity futures contract. For example an oil contract purchased at $89 and sold at $93 would produce a return of 4.49%.
Roll Return:●
Roll return occurs as a result of selling a futures contract (typically the near or current month) and purchasing a longer dated contract. This is referred to as rolling a futures position.
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If the contract price selling is priced above
the contract your purchasing, this creates a Positive Roll. A profit is achieved from simply rolling from the near month to a longer dated contract.
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If the contract your selling is below
the contract your purchasing, this creates a Negative Roll Yield
Collateral Yield:●
Unlike stocks, futures contracts are not purchased using cash but rather some for of collateral. A fraction of the notional amount is typically posted as
collateral in the form of (T Bills). The interest earned on the T Bills in this example is referred to as Collateral Yield.
How Correlated are the components in a Commodity Index
Sugar Cotton Cocoa Coffee Grains Livestock Energy Ind. Met Prec Met
Sugar 1.00 -0.01 0.08 -0.04 0.18 -0.05 -0.10 0.10 -0.00
Cotton -0.01 1.00 0.10 -0.03 0.18 0.05 0.06 0.24 0.09
Cocoa 0.08 0.10 1.00 0.02 -0.05 -0.04 0.08 0.09 0.13
Coffee -0.04 -0.03 0.02 1.00 0.06 -0.07 -0.05 0.07 0.02
Gains 0.18 0.18 -0.05 0.06 1.00 0.11 0.00 0.13 0.02
Livestock -0.05 0.05 -0.04 -0.07 0.11 1.00 0.02 -0.03 0.03
Energy -0.10 0.06 0.08 -0.05 0.00 0.02 1.00 -0.00 0.18
Ind Met 0.10 0.24 0.09 0.07 0.13 -0.03 -0.00 1.00 0.14
Prec Met -0.00 0.09 0.13 0.02 0.02 0.03 0.18 0.14 1.00
Based on month-end price changes for the period 1985 - March 31, 2003
Stocks within a Portfolio are approximately 0.65 Correlated to Commodities
Second and third generation Commodity Indexes –
Beyond Long Only
Commodity Facts:●
Commodities are Cyclical●
Commodities Trend Differently than stocks●
As proven by Claude B. Erb and Campbell R. Harvey in their paper
entitled “The Tactical and Strategic Value of Commodity Futures, the median compound annual excess return of individual commodity futures has been close to zero.
Heightened awareness and demand for commodities has caused a race to construct a “Better Commodity Index”
by most major investment banks and index companies. A sample includes:●
JP Morgan IGAR●
UBS Constant Maturity Index●
S&P Commodity Trends Indicator
These second and third generation commodity indexes allow investors to:●
Take advantage of the
Cyclicality of commodity futures by going both Long and Short●
Exploit futures prices at different points of the time curve●
Take advantage of certain commodities which are exhibiting greater positive price momentum than others
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Avoid steep losses in the event of a prolonged sell off in a certain commodity
Is there a Sound Reason to go Beyond Long Only?
$1 Invested In commodities in 1920 is worth about $1 Today
2.20
1.80
1.40
1.00
0.601920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Above represents the 17 commodities of the CRB Index adjusted for inflation
Second and third generation Commodity Indexes –
Beyond Long Only
Commodities are Cyclical
Stocks Exhibit a Substantially Different Historical PatternNotice the Line is upward sloping over longer periods: Exhibits No Real
Cyclicality
Second and third generation Commodity Indexes –
Beyond Long Only
Second and third generation Commodity Indexes –
Beyond Long Only
There Has To Be A Better Way! Looking back on the Corn Chart we see:●
Most Commodities Have Demonstrated Distinct, Polonged
Cycleswith prolonged periods of Negative Return
4 Years 4 Years
Some Second and Third generation Commodity Indexes are designed to take advantage of this:●
Cyclicality ●
Loss prevention (lower StDev)
Second and third generation Commodity Indexes –
Beyond Long Only
For simplicity, lets compare the S&P GSCI vs. S&P CTI.●
The S&P GSCI
is a long only commodity index and can only increase in value as commodities rise.
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The S&P CTI
is a long and short rules based commodity index (technically called an indicator by S&P)and it can increase in value regardless of whether commodities are rising or falling.
-60.00%
-40.00%
-20.00%
0.00%
20.00%
40.00%
60.00%
80.00%
Feb-
00
Jun-
00
Feb-
03
Nov
-00
May
-00
Aug-
00
Oct
-00
Jan-
00
Dec
-00
Oct
-04
Jan-
03
Sep-
04
Nov
-96
Jun-
96
Sep-
00
Nov
-98
Oct
-98
Aug-
98
Dec
-98
Jan-
99
Feb-
99
Sep-
98
Nov
-01
Dec
-01
Jul-9
8
Jan-
02
Feb-
02
May
-98
Jun-
98
Oct
-01
GSCI S&P CTI
15 Best & Worst performing rolling 12-month periods, 1991-2006
Best Periods Worst Periods
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S&P GSCI
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S&P Commodity Trends Indicator (S&P CTI)
Second and third generation Commodity Indexes –
Beyond Long Only
Statistics 1991-Sept 2007
S&P CTI PR S&P GSCI PR
Compound Annual 6.13% 2.04%Annualized STD 10.17% 18.70%Sharpe Ratio 0.2 -0.1Maximum Drawdown -18.57% -52.52%
Median 1-mo Return 0.30% 0.35%Avg 1-mo Return 0.54% 0.31%Raw Monthly STD 2.93% 5.40%# of Monthly Profits 110 108# of Monthly Losses 91 93% Wins 54.73% 53.73%Avg 1-mo Loss -1.94% -4.18%Worst 1-mo Period -5.71% -14.49%
Median 12-mo Return 5.50% 0.88%Avg 12-mo Return 7.24% 4.22%# of 12-mo Profits 138 99# of 12-mo Losses 52 91% Wins 72.63% 52.11%Avg 12-mo Loss -3.93% -14.58%Worst 12-mo Period -14.11% -42.02%
Annual Stats
Monthly Stats
Rolling 12-month Stats
Long/Short Long Only
Compounded Returns 6.13% 2.04%
Second and third generation Commodity Indexes –
Beyond Long Only
Annual Returns: 1991-Sept 2007
Significant long only out performance in these years still resulted in lower annualized returns due to significant losses incurred in 93, 97, 98, 01 & 06
S&P CTI PR S&P GSCI PRDec-91 -5.49% -11.19%Dec-92 6.72% 0.81%Dec-93 1.99% -14.98%Dec-94 9.17% 0.82%Dec-95 6.57% 13.76%Dec-96 26.16% 27.18%Dec-97 -5.44% -18.41%Dec-98 3.63% -38.83%Dec-99 7.10% 34.38%Dec-00 19.96% 41.10%Dec-01 -4.35% -34.31%Dec-02 -4.64% 29.93%Dec-03 4.54% 19.49%Dec-04 32.07% 15.64%Dec-05 9.33% 21.61%Dec-06 5.23% -19.07%Sep-07 -1.69% 15.00%
Long/Short Long Only
Second and third generation Commodity Indexes –
Beyond Long Only
Why the Significant Difference in Volatility and Return between Long only and Long & Short
A
B
Somewhere between Points A & B, the long/short index will get short (usually closer to A than B) and actually profit or rise in value from the down trend while the long only index can only lose in this precipitous decline
Summary
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Commodities are a significant source of portfolio Diversification
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Commodities Perform Best When the Financial Portfolio Performs Worst
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Commodities Provide a Hedge against Rising Inflation
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Commodities are Cyclical
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Some Second and Third Generation Commodity Indexes take advantage of this Cyclicality
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Long and Short Commodity Indexes can profit in both rising
and falling
commodity prices