Sent: 28-09-2010 10:48:09
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Commodity Investments: Can They Add Value?
Commodity investments are fashionable but the research says "buy and hold" will not work.
The flow of funds into commodity related investments has been growing dramatically. Barclays Capital estimated that US$292 billion was under management in commodity funds at the end of June 2010 after a further $14.6 billion had been raised in the prior month.
Several factors have come together to create the heightened interest, including:
- a recent history of strong absolute returns;
- the use of commodities as a hedge against anticipated losses in the value of the US dollar;
- historical evidence that commodities offer portfolio construction opportunities due to low (possibly negative) correlations with returns from more traditional investment classes;
- a surge in global liquidity supporting speculative activity in commodity markets;
- relatively low inventories of storable commodities which have fostered additional speculative interest; and,
- a focus by investment strategists on macroeconomic conditions in China and the investment classes most likely to benefit from its continuing growth.
Against this background, research on the characteristics of commodity investments and their potential effect on investment returns is focussing on:
- whether there is a continuing risk premium for investors in commodity markets;
- the connection between commodity investment returns and inventory levels;
- the extent to which momentum investing drives returns;
- the impact of the term structure of commodity derivatives on investment returns;
- whether anticipated diversification benefits from commodity investments could be lost as their popularity creates stronger linkages with the more traditional asset classes; and,
- the link between monetary policy and commodity investment returns.
The upcoming Edition 71 of the monthly ATC Digest reviews some of recent research findings with a bearing on the returns that can be expected from commodity investments and their likely impact when combined in portfolios with more traditional assets.
The article highlights the consequences for returns of commodity investments having to be made through derivatives rather than holdings of physical products.
One example of this impact was referred to in a recent survey of commodity funds published by International Advisor magazine. In the three years to June, according to the magazine's analysis, spot coffee prices increased by 47% while the main exchange traded fund tracking coffee prices returned only 9%.
The contango (i.e. the difference between spot prices and higher futures prices) creates potential losses for the non trade buyer of commodities. Coffee funds, in this instance, had to buy high futures prices and sell low nearby prices every few months as they rolled forward their derivatives positions to avoid taking delivery.
Pressure in this direction will vary in intensity. Over the two years to June 2010, the New York spot copper price fell by 24.0%. The iPath Dow Jones-UBS ETF, attempting to track copper market outcomes in which the term structure was relatively flat, returned -28.3%.
The differences between spot and futures prices and the differing roles of speculators and hedgers are continuing sources of analytical debate dating from the writings of British economists J M Keynes and Sir John Hicks and have underpinned much of the recent research on the role of commodity investments and their potential to enhance portfolio returns.
Claude Erb and Campbell Harvey in "The Tactical and Strategic Value of Commodity Futures" (Financial Analysts Journal, Vol 62, 2006) noted that "the average compound, geometric, excess return of the average commodity futures has, historically, been close to zero".
A paper by Devraj Basu and Joëlle Miffre (B&M) entitled "Capturing the Risk Premium of Commodity Futures" and published by the EDHEC-Risk Institute in February 2009 showed that an equally weighted long only benchmark produced a statistically insignificant mean return of 1.85% a year.
There is some historical evidence from the research of term structure, momentum and volatility persistence being guides to superior investment returns but, overall, the research support for commodities in an investment portfolio is highly nuanced.
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