Because of their unique return characteristics, commodities can be viewed as part of the real return portion of a portfolio. If the portfolio does not have such a separate allocation, then commodities can be viewed as a separate asset class entirely, to be evaluated alongside more traditional assets. If the objective is to provide better risk/return performance, and to provide better tracking of real returns, then commodities can potentially benefit the investor.
Finally, the index assumes unleveraged investment. For instance, if one crude oil contract (1000 barrels) is purchased for $60/bbl, this represents exposure to $60,000 of expected future crude oil prices. That one contract would be supported by an equal amount of T-Bills, which means that the total return would be the T-Bill rate, plus or minus the unleveraged change in the expected future price of crude oil.
Besides providing a return that reflects changes in inflationary expectations, a commodity index captures return from multiple sources. First is the return on assets that collateralize the futures positions. Indices typically use the T-Bill rate for this purpose, but in practice it is possible to use a portfolio of short term fixed income instruments or ILBs as collateral. Using high quality short term bonds as collateral normally provides a yield advantage, and potential price appreciation versus the T-Bills assumed in the index. Using ILBs as collateral takes it one step further, providing exposure to a “DoubleReal®” return, which refers to a strategy that provides exposure to two asset classes (commodities and ILBs) that have historically had a positive correlation to inflation. The second source of return comes from the fact that long positions in commodity futures markets assume price risk that commodity producers are trying to avoid. Economic theory says that those who assume risk are paid something for doing so. And commodity producers, because they have higher inventories and higher fixed costs than commodity consumers, are more subject to this price risk.Next, it can be expected that commodity prices will not be highly correlated to each other. The factors affecting natural gas prices are generally different from factors affecting corn prices, which are different from factors affecting coffee prices. If in fact these prices are not highly correlated, then a portfolio which rebalances its holdings as prices change should gain incremental return. Studies have shown that in fact commodity prices are not highly correlated with each other. Finally, sometimes in various commodity markets where inventories are low, we find that commodity processors will pay a premium for certainty of immediate supply. This can create a downward sloping forward curve. In that situation the commodity index investor might capture additional yield as they roll from a high priced nearby contract to a lower period distant contract.
PIMCO has more experience than many investment managers in managing commodity index derivatives, and we also have proven ability to manage the collateral backing these positions. It is this unique set of capabilities which allows us to implement customized commodity exposure for our clients. For our larger clients, we can implement exposure linked to any commodity index chosen by the investor. For investors who wish to gain short commodity exposure, we can manage portfolios that track the inverse return of a commodity index. We can further customize the management of the collateral to suit that investor’s risk requirements. PIMCO also manages commingled portfolios which invest in derivatives linked to various commodity indexes, and back those portfolios by investing in ILBs, providing exposure to a “DoubleReal®” strategy, or in high quality short term bonds.
The benefit of structural alpha strategies is that they are designed to offer a higher long-term risk-reward tradeoff, as conventionally measured by information ratio (alpha per unit of tracking error). By contrast, traditional active strategies can be “hit or miss,” and managers that are likely to deliver consistent “hits” after fees and expenses over long-term future investment horizons are difficult to identify. This is particularly true in the commodities markets, where outright price movements can be heavily influenced by factors that are difficult for active managers reasonably to predict (e.g., hurricanes, drought, freezes, disease, geopolitical events, labor strikes, etc.) These factors cause headwinds for traditional active commodities strategies and can create undesirable levels of tracking error in the process. We do not employ structural alpha strategies passively. Active management of structural alpha strategies is critical to optimizing risk and return. Some commodity managers/counterparties advocate employing one structural strategy (or a small number of combined strategies) as a passive, pre-specified, rules-based approach to outperform a commodity index. This approach, in our view, has critical shortcomings. First, it limits the opportunity set of available strategies. Second, it assumes that the historical conditions that gave rise to excess returns in the past will endure unchanged into the future, and at comparable levels, which is a dangerous assumption. Third, it assumes that these structural conditions will endure consistently, without meaningful fluctuations over short-term or calendar periods. By contrast, PIMCO’s approach is to implement multiple, concurrent structural alpha commodity strategies using experienced judgment, proactively adjusting exposures based on the current and changing attractiveness of risk and return, just as we do with alpha strategies in bond portfolios.
PIMCO uses derivatives linked to individual commodities or commodity indices to gain basic exposure to the asset class, including any structural strategies. This provides exposure to the investment returns of the commodities markets, without investing directly in physical commodities. Investments in commodity-linked derivative instruments may subject the portfolio to greater volatility than investments in traditional securities.PIMCO adjusts the notional amount of those derivatives as the market value of our accounts changes, so that our notional exposure to an index is targeted at 100% of the account value. This exposure is monitored daily, and all derivative positions are marked to market daily. PIMCO also monitors its counterparties closely, ensuring not only that their credit is acceptable but also that they have a well-run commodity desk. We typically settle any derivatives at least once a month, and we exercise PIMCO’s normal diligence in management of collateral that backs the commodity index positions.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. PIMCO strategies utilize derivatives and commodity-linked derivatives which may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. Swaps are a type of derivative; while some swaps trade through a clearinghouse there is generally no central exchange or market for swap transactions and therefore they tend to be less liquid than exchange-traded instruments. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. There is no guarantee that this investment strategy will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Diversification does not ensure against loss.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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