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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 a real return 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 both better risk/return performance and 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 (1,000 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 dollar 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 returns from multiple sources. First is the return on assets that collateralize the futures positions. Indexes 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 to provide Double Real® returns, a strategy that provides exposure to two asset classes (commodities and ILBs) that have historically had a positive correlation to inflation.
Next, investors can expect that commodity prices will not be highly correlated to each other. Indeed, studies have shown they are not. The factors affecting natural gas prices are generally different from those affecting corn prices, which are different from those affecting coffee prices. Therefore, a portfolio that rebalances its holdings as prices change should gain incremental return.
Finally, sometimes in various commodity markets where inventories are low, commodity processors will pay a premium for certainty of immediate supply. This can create a downward-sloping forward curve, and a commodity index investor might capture additional yield by “rolling” forward from a high-priced nearby contract to a lower-priced 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 that allows us to implement customized commodity exposure for our clients. For our larger clients, we can implement exposure linked to any commodity index the investor chooses. 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 collateral management to suit that investor’s risk requirements. PIMCO also manages commingled portfolios that invest in derivatives linked to various commodity indexes and back those portfolios by investing in ILBs, providing exposure to a Double Real® strategy, or in high quality short-term bonds.
We do not employ commodity alpha strategies passively. Active management of these strategies is critical to optimizing risk and return. Some commodity managers/counterparties advocate employing one 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 market conditions will remain static, without meaningful fluctuations over short-term periods. By contrast, PIMCO’s approach is to implement multiple, concurrent commodity alpha 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 indexes to gain basic exposure to the asset class, including any active commodity 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 do.PIMCO adjusts the notional amount of those derivatives as the market values of our accounts change, 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 closely monitors its counterparties, 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 the 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, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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