| Role of Commodities in a Portfolio |
Commodities provide a combination of diversification plus inflation hedging. Even with an assumption of modest returns, commodity investment has the potential to improve the risk/return performance of a portfolio. Direct exposure to commodity prices, via an index, is more effective than using the purchase of equity in commodity producers. The index directly reflects changes in expected future commodity prices. Share prices of commodity producers, on the other hand, will also be affected by the financial structure of the company, by management’s price hedging activities, and by movement in the overall equity markets.
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.
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| Measuring Commodity Returns–An Index |
To measure the returns of commodities as an asset class, the investment industry typically relies on indices that calculate the returns to a hypothetical portfolio which contains only long positions in commodity futures contracts, passively managed, on a fully collateralized basis. Only long positions are considered, so that the portfolio will consistently benefit if commodity futures prices rise. Only commodity (and not financial) futures are considered, so that the asset class remains distinct from stocks and bonds. The index represents holding positions according to a set of rules that are administered passively. These rules typically require that commodities which are more important in world trade are more important in the index. The index further assumes that positions are consistently rolled forward, so that the investor who is looking for index-like returns is always exposed to changes in the expected future prices of the actual commodities.
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. |
| Commodities–Expected Pattern of Returns |
A commodity index reflects the expected future prices of products which, collectively, represent over $2.0 trillion of global annual production. So, if the markets decide that inflation is going to be higher than previously thought (i.e. that the rate of inflation is going to rise), then it is reasonable to assume that the expected future price of some of these commodities will rise also. And in fact, historically, commodity indices have had a positive correlation with changes in the rate of inflation. At the same time, rising inflation is often negative for stock and bond returns. These differing responses to inflation have historically caused commodity indices often to have a low or negative correlation to equities and fixed income, providing diversification for a portfolio. And that same economic response to inflation changes can make commodities an attractive inflation hedge, which may help investors whose liabilities are in real terms (i.e. those investors who need to maximize the amount of goods and services that their portfolios will buy in the future).
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. |
| Sources of Added Value |
Because commodity contracts ultimately settle at prices based on prices in the cash markets, they are directly linked to the large size of those markets. But the futures markets themselves are quite large and liquid as well. Nevertheless, since those markets are quite varied, most investors choose to invest in derivatives linked to a chosen commodity index. Those derivatives may be exchange-traded index contracts, or over-the-counter notes and swaps. In all these cases, one potential source of outperformance is the management of the collateral which backs the derivatives position. A second source of potential outperformance is that recognition of structural aspects of future markets might allow for more sophisticated replication strategies than those defined by the published index.
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. |
| Commodity Structural Strategies |
PIMCO is increasingly evaluating and implementing commodities-based strategies as an additional way to further potential value. We are primarily focused on structural alpha strategies, which are strategies based on structural pricing aspects of the commodities markets and indexes. Structural alpha strategies seek to add value by taking advantage of identifiable economic factors that create patterns of risk premia, minimize negative roll yield, and provide other techniques in an attempt to generate returns that are incremental to a published index. These are distinguished from traditional active commodities management, which is based on outright technical and fundamental views that directly over- and under-weight and go short individual commodities or commodities sectors.
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.
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| Risk Management / Controls |
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. |