Commodity exposure without diversification

The latest numbers on the amount of money invested in commodities were reported in the press. There is close to $367 billion in assets under management in commodities with a boost of $5.2 billion in the first quarter. Once the numbers are reviewed in more detail it is less clear whether investors are using commodities as a a diversification tool.

$155 billion of the $367 billion is in ETP's. This is the portion that is treating the commodity markets like another equity market. $120 billion of the ETP AUM is associated with precious metals, $9 billion is linked to the energy markets, and only $19.5 billion is exposure to the broad based commodities.

It s surprising that the majority of the ETP exposure is concentrated in gold which does not track or represent broad based exposure to commodity markets. Investor are not buying commodities for their diversification benefit as much as they are buying for the unique exposure to the gold market. If the conditions for gold change, these investors will be disappointed and they would never have received the price appreciation from the supply shocks across the broad set of commodity markets.

ECB and rate tightening - QE at a price?

The ECB has taken the first step to control EU inflation by raising rates from 1 to 1.25 percent. This is the first time that the ECB has raised rates since 2008. ECB president Trichet, however, stated that monetary policy is still "very accommodative". The reason for the rate raise has been the increase in inflation above the 2% target set by the central ban. Many are perplexed by the increase given the sovereign debt crises and the fact that the inflation increase is loosely tied to food and energy costs. While Germany s doing well, many of the other euro countries are seeing a fragile recovery.

This action certainly is at odds with the views of Fed chairman Bernanke. It is seldom that the ECB will take the lead relative to the US central bank. Our take on the action is that it sends a signal to the market that the ECB wants to be viewed as an inflation fighter even though they are willing to provide a significant amount of liquidity. Their policy is quantitative easing at a price; nevertheless, the price is not high given that real rates are still below zero.

Tail risk and the shocks of March

Commodity markets saw increased volatility with both the Japanese earthquake and the Libyan crisis creating tail events which drove market flows to safety. Both events were unexpected in size and scope and caused an increase in the market risk premiums and herding behavior as a reaction to the unknown. Nevertheless, strategy and market diversification provides an easy way to protect against tail events especially those that are concentrated to one market or asset class.

Tail events, however, can have a mixed effect for active trading if there is limited follow-through or sudden reversals. Active trading may cut exposures at the wrong time through automatic stop-loss methods; consequently, it is critical that traders carefully assess unique market situations. As portfolio managers, it is all the more important to understand the mix of trading strategies within an active portfolio.

What makes a tail event?

The current buzz in risk management has been on hedging tail events, yet there seems to be little discussion on what constitutes a tail event and tail risk. Should a tail event be defined as a unique or surprise market situation which does not occur frequently, or should it only be a price move that falls in the extreme left hand side of the sample distribution. The distinction is important. Rare events do not always generate large price moves and not all price moves are tied to rare events.

Broad generalization concerning the chance occurrence of “black swan” events does not have meaning without acknowledging that surprise events have to be tied to market reaction and to the underlying knowledge about the probability of rare events. One man’s tail event may have been fully anticipated by another. Tail events and risk are related to the knowledge or scenarios generated by a portfolio manager. Additionally, tail events have to be placed in the context of probability and size. It is the exposure not the chance that determines risk.

In the case of the Japanese earthquake and the nuclear disaster afterwards, the sequence of events was not anticipated by the market. By that definition, those were tail events, but a close examination of price action suggests that they were not broad tail events as measured through longer-term time horizons or across all asset classes. The shocks from the financial crisis of September 2008 were deeper and more broad-based. Still, it may be early to see the longer-term implication of these events.

Of course, the immediate reaction to the earthquake was a strong negative move. For some companies and localized markets, this natural disaster tail event is unquestionable and will be long-lasting. However, for a broader global portfolio, the tail event impact of a localized shock is less clear. Many markets by the end of March were higher and look as though they have not been affected by the earthquake. In that sense, was the earthquake a true tail event?[1] Similarly, for longer-term investors, the definition of a tail event is unclear. Monthly returns were in many cases not out of the ordinary. Hence, tail events have to be looked through the context of time horizon, trading activity, and portfolio diversification. Tail event risk is most easily mitigated through the broadest form of diversification.

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[1] An oil price shock from the Libyan uprising could be considered a different type of tail event. While the place and timing of the oil price shock was a surprise, the fact that there will be a price spike on Middle East unrest is well-known and the expected price response is more predictable. The trading behavior should be different in this situation.

Central bank communication - is there too much?

The courts had to force the Fed to reveal the list of borrowers from the discount window. The information showed foreign banks as the largest users of the Fed facility. Th information was embarrassing that fact that Fed had to be forced to provide the information as not a shining moment of transparency. However, the financial world did not stop and the truth did not cause a massive sell-off for financial institutions. Central bank communication is good.

However, too much central bank information can also be a problem. Fed Chairman Bernanke is planning to hold a regular press conference starting at the end of April. While this should be informative, it creates a new set of problems. Markets will be focusing on the verbal communication of the Fed and not the actual fundamentals numbers. Communication can be subject to nuance and subtlety. It can be ambiguous on a turn on phrases. Do you believe the words from the central bank or the actual money flows? Academic research already shows that the market will jump on communication changes. Should the market be surprised by Fed announcements?

Communication can best come through consistent, stable and clear policy actions. If this is done, there may not be a strong need for the speeches and press conference.

This reminds me of the My Fair Lady song, Show Me,


Never do I ever want
to hear another word.
There isn't one
I haven't heard.
Here we are together
in what ought to be a dream;
Say one more word and
I'll scream!


Sing me no song!
Read me no rhyme!
Don't waste my time,
Show me!


Please don't implore
Beg on the seats
Don't make all the speech
Show me!