Commodities: Agility Matters
Attracted by the hunt for returns, diversification and potential for hedging inflation and macroeconomic risks, investors have increased their allocations to commodities over the past ten years, primarily through passive investment into commodity futures indexes.(Source: Investment Company Institute)
Periods of volatility in commodities markets have refocused the discussion on the role of the asset class in strategic and tactical asset allocation, and highlighted the relevance of strategies that can take advantage of, or protect against price trends.
The Standard & Poor’s GSC Index of 24 raw materials rose as much as 12 percent this year before slumping 13 percent in May and rebounding 0.5 percent in June. The measure is down 2.7 percent since Dec. 30. (Source: Bloomberg)
Brent crude, the benchmark for more than half the world’s oil, slid 3.8 percent in 2012 after reaching an almost four- year high of $128.40 per barrel on March 1. U.S. natural gas has gained 44 percent since falling to a 10-year low of $2.175 per million British thermal units on April 20.
And although volatility is low in commodities as this article is being authored, when volatility strikes, no matter what the commodity, it’s easy to understand how a long-only strategy might suffer. But why then would a long/short strategy − one that’s designed to capture two-way market trends – not perform well?
Your Friend The Trend, is …well… Less Trendy
In the case of long/short index strategies, most of them typically seek to identify trends in specific commodities at the start of each calendar month, and hold those positions until the end of the month, adjusting their holdings about 12 times per year.
The chart below plots commodity price trends as represented by the S&P GSCI, over the past ten years. As you can see, trend characteristics have changed somewhat during this time, most notably their length. The most prominent examples of extended trends are periods during 2007 and 2008, when a sustained sharp upward trend was followed by a sustained sharp drawdown. Across those two periods it’s clear why long-only strategies were not able to perform well and were over shadowed by long/short strategies – especially those that went long and short at the right time.
10-Year Performance of S&P GSC Index
Source: Bloomberg. Date range: 8/301/02-8/30/12. One cannot invest directly in an index.See index description below.1
But what happens when price trends become less stable? We need only look back as far as this past year to see that when prices move in less orderly fashion. It’s difficult for any fund to be able to capitalize, if it’s only allowed to adjust its positions at pre-set calendar dates. Recently, for example, from June 2011 through June 2012 commodities prices fluctuated from week to week. With no definitive trend, long-only and long-short strategies that were not able to change positions intra-month were equally vulnerable. Whether long-only or long/short, many funds indeed had difficulty managing the volatility. Markets don’t pay attention to the date. They’re fluid and respond only to supply and demand.
Charles Darwin said, It is neither the strongest of the species that survive, nor the most intelligent, but the one most responsive to change. The ability to adapt to change – in any market, no matter what the asset class – is an advantage. And as events in Europe continue to evolve, China attempts to avoid a deep downturn, the U.S. straddles the fiscal cliff, and severe weather wreaks havoc; commodities strategies must be more responsive and adaptable in order to succeed.