Managing Risks/Returns in the Commodity Market

by: , Director, Product Management

In our previous blog titled “Commodities: SPOTting the Real Opportunity,” we discussed the signals around timeliness, coupled with the benefits of having exposure to commodity spot prices.

In this blog, we’ll cover the two primary methods to access commodity spot price movement: futures-based and equities-based. While both have benefits and drawbacks, we have identified a strategy that resolves most of the drawbacks from these methods.

Futures-Based

Broad basket commodities, including strategies that utilize futures contracts, are generally accepted to provide the strongest correlation to spot price movements. A futures contract is simply an agreement to purchase a specified amount of the commodity in a specified month at a specified price. Therefore, the value of possessing this contract will move as the underlying commodity price moves, thus providing a highly correlated access to that price.

One of the issues with futures contracts, however, is that they expire and typically have a positive time value. As we previously discussed, commodity prices tended to generally follow inflation. We should then expect commodity prices to generally rise over time. If I purchase a futures contract to buy an amount of a commodity in the future, I would likely pay a premium to ‘lock in’ today’s price. The further out the contract is dated, the higher premium I would typically pay for the contract. This concept is known as ‘contango.’

A commodity fund, using futures, has no interest in executing the contract and taking delivery of the commodity itself. As time passes and the contract approaches maturity, the time value (premium) dwindles, and the fund will eventually have to sell the position. A new contract will have to then be purchased and, if in contango, it will cost more to replace a short-dated contract with a longer-dated contract. This process of constantly renewing the positions naturally erodes performance, as demonstrated below:

Spot Prices vs. Futures-Based Returns

Source: FactSet, 2018. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

Another issue with futures-based strategies is that the majority is structured as partnerships, which issue K-1 income. As a result, the partnership must prepare a Schedule K-1 to report each partner’s share of these tax items. Several funds have been developed to address the K-1 concern, but they run into a different type of tax issue, where the K-1 erasing mechanism can convert capital gains into high-taxed ordinary income.

Lastly, some segments of commodities have small depths of the market. For example, energy forward contracts have three times the number of contracts in existence, compared to agriculture contracts.1 In an attempt to prevent price manipulation and congestion, the Commodity Futures Trading Commission set forth specific regulations around how much of a contract a trader can hold. Therefore, as a futures-based fund grows in size, its ability to hold a significant position in a smaller segment of the market becomes restricted. With energy being one of the largest futures market for commodities, it’s not surprising that energy tends to be one of the largest holdings of futures-based strategies.

Equities-Based

Now, let’s discuss the equities-based method. Natural resources fund strategies allocate their assets to equities from companies that are strongly tied to commodities. The argument is that future company growth is strongly influenced by the spot price of the commodity.

While equities-based strategies solve the futures-based concerns of contango, K-1, and market depth, another type of risk is introduced: increased correlation to equity markets and, subsequently, additional volatility. The Morningstar Natural Resources Fund Category, for example, has exhibited a higher standard deviation than the Bloomberg Commodity Spot Index and both domestic and international equities (represented by the S&P 500 and MSCI EAFE Indices) over a five-, 10-, and 15-year basis. This clearly shows that volatility attributed to equity market influence compounds the volatility attributed to spot price movements.

Standard Deviation

5-Year 10-Year 15-Year
US Fund Natural Resources 17.58 24.89 22.53
BBG Commodity Spot PR 12.59 17.98 16.91
S&P 500 TR USD 9.49 15.08 13.26
MSCI EAFE NR USD 11.67 18.5 16.45

Source: Morningstar, as of 12/31/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

Finding Common Ground?

The equity markets exhibit a “push and pull” on natural resources equities that subdue the case for equity diversification and compound volatility on top of spot price movements. Given this dynamic, it makes sense to identify a solution that addresses the equity market influence. Providing a short exposure to both a broad domestic equity exposure (S&P 500) and international exposure (MSCI EAFE) would deliver returns opposite the index. For example, if the S&P 500 delivers a 2% return, the short exposure would lose 2%, and if the S&P 500 loses 3%, the short exposure would gain 3%.

Combining an equity market short exposure with the natural resources exposure would “pull” when the market “pushes” and “push” when the market “pulls.” The next step is to determine just how much of an effect the market has on natural resources equities.

The ultimate goal of testing an optimal market short exposure is to achieve similar volatility, up/down capture, and beta to the Bloomberg Commodity Spot Index as the futures-based broad basket commodities index. In doing so, it would mitigate the equity approach’s drawbacks, while eliminating the drawbacks of futures-based strategies, since futures contracts are not utilized.

To put this concept to a test, consider a period when the Morningstar Natural Resources Fund Category exhibited its strongest correlation to equities, making it most vulnerable to properly access spot price influence. As seen below in the one-year trailing period, correlation rose and remained near 1 (the strongest correlation) from mid-2009 through the end of 2011. Considering this is rolling one-year correlation, we should start at the middle of 2008 and look through the end of 2010 to examine the high correlation period.

Natural Resources Fund Category’s Rolling One-Year Correlation

Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

The sweet spot of maximum reduction of standard deviation, while maintaining total return over the period analyzed, looks to be a hedge of 7% to domestic equities (S&P 500) and 7% to international equities (MSCI EAFE), with a reduction of the long position to 95%. The down capture of the Morningstar Natural Resources Fund Category (with these hedges implemented) to the Bloomberg Commodity Spot Index comes in at 98%, with an up capture of 83%. This is almost identical to that of the Morningstar Broad Basket Commodity Fund Category (82% up capture and 98% down capture). What’s more, beta to the Bloomberg Commodity Spot Index was .931, in line with the beta of .935 for the Broad Basket category.

Spot Down Capture Spot Up Capture Spot Beta Average Correlation to Equities
Natural Resources Fund Category 104.1% 103.4% 1.063 0.719
Natural Resources with 14% Equity Hedge 98.1% 82.9% 0.931 0.689
Broad Basket Fund Category (Futures) 98.3% 81.7% 0.935 0.654

Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

After bringing the relevant metrics back near that of what an investor would access with futures performance, total return over time, as seen below, not only remains strong, but looks to better track the Bloomberg Commodity Spot Index than unhedged natural resources:

Growth of $100

Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

1. Source: CME Group, as of 3/18/2018.

About Risk:

All investments are subject to market risk and will fluctuate in value. Past performance is not indicative of future results. An investment cannot be made in an index. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors, who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the federal government, as to the timely payment of principal and interest. Diversification does not ensure a profit or protect against a loss in a declining market.

Neither New York Life Investment Management LLC, its affiliates, nor its representatives provide tax, legal, or accounting advice. Please contact your own professionals.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Bloomberg Commodity Spot Index (BCOMSP) measures the price movements of commodities included in the Bloomberg CI and select subindexes.

Commodity refers to investments in instruments and companies that are susceptible to fluctuations in certain commodity markets. Any negative changes in commodity markets (that may be due to changes in supply and demand for commodities, market S-4 events, regulatory developments, or other factors) could have an adverse impact on those companies.

Commodity Futures Trading Commission is an independent U.S. federal agency that regulates the commodity futures and options markets.

Correlation is a statistic that measures the degree to which two securities move in relation to each other.

K-1 income is a tax document used to report the incomes, losses and dividends of a partnership.

Morningstar Broad Basket Commodity Fund Category is defined as portfolios that can invest in a diversified basket of commodity goods, including but not limited to, grains, minerals, metals, livestock, cotton, oils, sugar, coffee, and cocoa.

Morningstar Natural Resources Fund Category is defined as natural resources portfolios focused on commodity-based industries, such as energy, chemicals, minerals, and forest products in the United States or outside of the United States.

MSCI EAFE Index measures the performance of equity markets in Europe, Australasia, and Far East markets.

Standard deviation is a statistical measurement; when applied to the annual rate of return of an investment, it sheds light on the historical volatility of that investment.

S&P 500 Index is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.

The information and opinions contained herein are for general information use only. IndexIQ does not guarantee their accuracy or completeness, nor does IndexIQ assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are as of the date of this report and are subject to change without notice. Past performance is no guarantee of future results.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, New Jersey 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Dan Petersen, CAIA®

Director, Product Management

Dan Petersen is a Product Manager at IndexIQ, responsible for developing actionable content as it pertains to the competitive landscape, analyzing fund usage in the latest market environment, and portfolio positioning for both individual portfolios and broader-based applications

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