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 Portfolio Diversification with Commodities Investment opportunities for the next decade
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Summary
This document summarises the three day conference “Portfolio Diversification with Commodities Investment opportunitiesfor the next decade” that focused on the case for commodities as an asset-class as well as variations in index constructionand out-performance of the indices available through dynamic, theme-based trading strategies. Robert Greer chaired theconference
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. The conference summary will not repeat arguments for a commodity investment in depth but focus onanecdotal issues and potential ideas for further action.Among institutional investors there remains considerable demand for commodities as a long-term portfolio diversifier. Theaudience consisted of institutional investors. Conference sponsors and partners
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presented brochures, product flyers,research and gimmicks. They promoted their commitment to commodities as an asset class and used the opportunity to present new products, their business and research views. For example SocGen presented an Oil Index tracker certificate,while Barclays introduced a product innovation Collateralized Commodity Obligations providing an opportunity for investors to access exposure to a basket of commodities in an established fixed income format. Jeffereis will concentratetheir focus on commodities with the first steps being launching future contracts on the revised CRB Index.Key speakers were leading commodity experts with extensive business background. Audience interest was high withattendance level varying between 80 to 110 people each session. The consensus amongst participants was that investorswould move away from benchmark indices to use active strategies to exploit commodity market characteristic inefficiencies.In equity markets every investors has the same objective and moves instantly into an opportunity while in commodities thismust not be the case. For example a trader who hedges Kerosene for an airline may identify an opportunity in coal but is notallowed to exploit it.Recurring points of discussions were the Contango
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in the energy markets plus the funds already invested in commodities.The futures open interest of the underlying commodity markets is in excess of $210 billion. The total size of the underlyingmarkets is a multiple of this number if the over-the-counter market is included. The potential size of the underlying marketsis over 1 trillion USD annually, if all commodity production was fully hedged. Investment in commodities is lead by Swaps(65%), 25% Structured products and 10% Futures. The commodity index market size of 1999 was an estimate of USD12bln,while at present it’s about USD60bln. The estimates varied from USD1-2bln for the RICI, USD15bln in the Dow Jones-AIG
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(up from USD500m from the beginning of 2003) and USD5bln in the Deutsche Bank Liquid Commodity Index(“DBLCI”). Investment in the GSCI index is now over USD35 bln, which has nearly tripled since 2002. Some participantswondered if the recent positive commodity index performance was simply a result of higher energy prices. The footnotes listthe speakers’ credentials. Nearly all presentations are available from me on request as a PDF-document.
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23rd-24th May 2005 and Interactive Workshops: 25th May 2005 in London
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Bob Greer, Real Return Product Manager, Pimco, was the first person to define an investable commodity index or to advocate it as a separate asset class.For eight years he managed the commodity index business, first of Daiwa Securities, and then of Chase Manhattan Bank and JPMorgan. These many yearsof real asset investment experience have come together in Mr. Greer’s current position at PIMCO, where he is a Senior Vice President and Manager of RealReturn Products, a product line which embraces commodities, inflation-linked bonds, real estate, and active asset allocation.
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Societe General, Jefferies, Goldman Sachs, Barclays and Deutsche Bank were visible sponsors and partners.
 
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When a futures contract’s price is at a discount to the spot price, the shape of the futures curve is called backwardation. When the futures contract’s priceis at a premium to the spot price, the shape of the futures curve is called contango. Most observers find the difference between typically backwardatedversus typically contangoed markets to be storability of the specific resource. Gold, for example is easy and cheap to store; it is therefore typically incontango. Oil, on the other hand, is more difficult and expensive to store; it may therefore be more frequently backwardated. An explanation is thatdistinguishes between markets that provide a hedges for producers (backwardated markets), and markets that provide a hedge for consumers (contangomarkets).
 
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USD9bln by Pimco alone
 
 
Individual Topics
The case for commodities as an asset-class: strategic and tactical issues
, Benno Meier 
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, presented the well knownarguments for an investment in commodities which are: Risk-return profile enhancement, Correlation and portfolioefficiency benefits, strong returns in rising inflation regimes (especially in the US when Heating Oil entered the US CPImethodology in 1983. However the trend to more service oriented economies has reduced the commodity-CPI impact),transparent compared to other alternative investments, such as Private Equity or Hedge Funds.
Components and drivers of return for commodity investments
, Robert Greer’s, Real Return Product Manager, Pimco, presentation explained the fundamental economic drivers of those returns, in the context of a commodity index, including:What is the basis of returns you could expect from commodity indices?Components of Return: Causes of Return:T-Bill Rate
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Expected Inflation (plus real rate of return)Risk Premium
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Price Uncertainty (producers vs. processors)Rebalancing
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Uncorrelated Volatility (mean reversion)Convenience Yield
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Low Inventory Relative to DemandExpectational Variance
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Unexpected General Inflation; Plus… Individual market “surprises”Economic factors that are favorable for commodities:
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Secular reflation
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Mitigated by excess global supply of labor and manufacturing capacity
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Commodity infrastructure has suffered from low investment
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Commodity demand continues to grow (Increase in per capita demand in emerging economies)Leading to:
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Producers need expectation of stable prices to spur investment
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Processors will require “convenience” of secure supplies when inventories low
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Bottlenecks may mean that “surprises” are more likely to be to the upside
 Real insights on real assets: a practitioner's perspective on commodities
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, Adam C. De Chiara
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, presentation emphasizedon the role of Alpha
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and Beta within the asset class. How you own commodities can be more important than whatcommodities you own. Index construction (Rollover schedule) becomes crucial. Adam recommended a dynamic vs. a staticRollover schedule to generate outperformance.
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Benno, Investment Strategist, Barclays Global Investors, is the Head of Commodity Strategy within Europe's Global Index and Markets Group. Thisincludes assisting with efficient distribution of commodity products, product development, monitoring demand and competitor developments, andresearching optimal portfolio holdings and investment strategy. Before focusing exclusively on commodities, Benno was a member of the InvestmentSolutions group, which utilised BGI's range of capabilities to design investment solutions for strategic clients. He has also served as the assistant to the Co-CEO and Head of the Global Index and Markets Group, fulfilling the role as project manager on designated initiatives within the group.
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Presentation is not available as a PDF-document.
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Mr. De Chiara is the Co-President of Jefferies Financial Products, LLC ("JFP"), a wholly owned subsidiary of Jefferies Group, Inc. Founded in 2003 by ateam of experienced commodities professionals, JFP is a company uniquely dedicated to providing institutional investors with exposure to commodities asan asset class. JFP provides exposure to all major commodity indices and also provides customized solutions for obtaining exposure to real assets. Prior to joining Jefferies, Mr. De Chiara founded and ran the commodity index department of AIG Trading Group. Over his 9-year career at AIG, Mr. De Chiarawas responsible for a number of business initiatives including the design, launch, marketing and trading of the Dow Jones – AIG Commodity Index. Prior to joining AIG, Mr. De Chiara traded commodities for the J.Aron division of Goldman Sachs, where his duties included trading futures, swaps, notes andother derivatives linked to the Goldman Sachs Commodity Index.
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Alpha is a measure of the return generated by a investor relative to the market. Alpha is a coefficient measuring the risk-adjusted performance,considering the risk due to the specific underlying, rather than the overall market. A large alpha indicates that the underlying has performed better thanwould be predicted given its beta.
 
 Factors driving commodity allocation decisions
, Alisdair MacDonald
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, focused on what is constraining, and encouraging,commodity investment by institutional investors. Only three institutional investors had commodity exposure in the audience.Governance will limit a large and quick commodity exposure of UK pension funds. Commodity investment options for institutional investors are:
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Swap
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Enhanced index
 
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Actively managing roll, transaction costs and collateral
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Active
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Few products available (but increasing)
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Limited track records
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Limited capacity
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CTAs/Managed futures
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Hedge fund fees
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Reduced exposure to commodity beta
 A comparative review of commodity index investment opportunities
, Rian Akey
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, focused on an active approach todetermine which index, if any, may provide the best investment opportunity. I must recommend this presentation because itgave an excellent overview on commodity index similarities, differences, performance and diversification characteristics.Commodity indices have progressed from an economic indicator (CRB) to an investor friendly product (DBLCI). Notsurprisingly the RICI produced, for the period of the study, the highest average annual rate of return at 21.92%, followed byGSCI at 19.95%, but because RICI is more diversified than GSCI, its standard deviation is lower. The Sharpe Ratio of theRICI is the highest of all commodity indices. However the RICI is also the most expensive one with approx. 200bpsexecution costs.
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Alasdair Macdonald, Investment Consultant, Watson Wyatt, studied mathematics at Trinity College, Cambridge, and joined Watson Wyatt in 1999. Heworks as an investment consultant, advising institutional investors on their investment strategies. His clients include some of the largest UK defined benefit pension funds, as well as defined contribution schemes, insurance companies and endowments.
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Likely to be preferred approach until market develops further 
 
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Rian Akey is the Vice President and COO of Cole Partners and Cole Asset Management and is responsible for overseeing the firms’ research andoperations. Rian was hired in 1999 as the firm's director of research. In 2003 his role was expanded to include business development and operationaloversight responsibilities. In 2005, Cole Asset Management launched a multiadvisor fund dedicated to the natural resources sector; Rian is on theinvestment committee for the fund. His article “Commodities: A Case for Active Management” is available on the firm’s website atwww.colepartners.com.
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