Tuesday, April 17, 2018

Long/short commodities - Adds value to equity and bond portfolios

Static investments in long-only commodity indices have had a checkered past since the financial crisis. With the end of the commodity super-cycle, there has been a long commodity unwind and passive investing in commodities has generated negative annualized returns for investors for years. There has not been any bounce to pre-crisis level like we seen in equities. The interest in commodities as an inflation hedge has waned with this poor performance.

Of course, the dynamics of commodity prices are different from other asset classes where value is determined by discounted future cash flows. Commodities indices, as constructed through futures contracts, are driven by current demand, production, and inventory changes and not long-term future cash flows. Nevertheless, the investment environment may be changing in favor of commodities. See:

Over the past decade, there have been a explosion of commodity alternatives often referred to as second and third generation indices that have reduced risk and provided positive returns independent of the long commodity cycle and long-only indices. These long/short indices have focused on commodity risk premium and have included momentum, carry and fundamental focused rules-based investments. Expressing commodity exposure through the underlying risk premium in these markets allows investors to capture the behavior of commodities but in a way that is not as sensitive to the long swings in price and can exploit the unique differences across markets include in a commodity basket. See:

Recent research from Tom Erik Sonsteng Henriksen, "Properties of Long/Short Commodity Indices in Stock and Bond Portfolios" in the Spring 2018 Journal of Alternative Investments further confirms the distinctive features and value of long/short commodity investing through analyzing some existing investment funds available to investors. There has been a significant decline in performance since the launch of these funds, which corresponds to the post-Financial Crisis period, but the shortfalls relative to the pre-crisis periods are significantly lower the what has been seen with long-only investing. When added to portfolios of stocks and bonds using a variety of portfolio allocation methods including variations on risk parity, the author finds that returns are lowered especially in the post-crisis period, but there also is significant risk reduction and a general improvement in the return to risk ratio.

Our take-away is that employing long/short commodities indices comprised of risk premiums have diversification benefit but the potential for return enhancement is mixed and affected by the time period analyzed. Since the study looked at funds that have singular purpose like momentum or carry, there is still room for further analysis on the impact of bundled risk premium portfolios. Nevertheless, there is value in looking at enhanced commodity allocations at this time given the higher potential for inflation, better overall commodity environment, and the continued global economic growth.

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