The commodities wheel of fortune

In the current commodities bull run, retail investors have had access to a huge range of products to gain exposure. As a result, investment is shifting from broad-based diversification to increasingly sophisticated strategies. But will greater risk appetites leave investors at the mercy of volatile markets and speculators?

Three years ago, a commodity investment meant prudent investors placing a perfunctory 3% slice of broad-based index exposure in their portfolios. Attention focused on the active management of the other usual asset classes like equities and credit, with few second thoughts to what was principally a hedge. But now that the boom in commodities has firmly fixed itself in the investor mindset, commodities investment has undergone a permanent shift. In contrast to the upturns of the twentieth century, retail investors have been presented with a plethora of new ways to access commodities, many of which give them precise control and allow greater sophistication than simple diversification.

These are much-needed developments. Commodity growth, while part of a general trend, is not uniform. Each commodity exhibits a differently shaped yield curve and some markets, such as agriculture, have very high short-term volatility. Despite widespread coverage of rising wheat prices, the S&P GSCI Wheat index was up 13.89% in February 2008, yet tumbled 14.35% in March. As a result, a more in-depth approach is necessary. Retail investors are now taking a view on separate products like cocoa, sugar, or wheat, in the same research-driven way that they might have once approached individual stock investment. They are also looking at products that let them play the downside as well as the upside.

"I think the high-net-worth individual is more likely to use commodities for portfolio diversification, whereas your regular 'Joe six-pack' has been taking more of a view on the markets," says Eric Kolts, New York-based vice-president of the S&P GSCI, which is the benchmark commodity index. "What is interesting about this boom cycle is that there are financial products available for the regular investor that allow them to access commodity markets that weren't there before, like exchange-traded funds (ETFs) and exchange-traded notes (ETNs)," he adds.

The huge investor inflows into these products show the extent to which participating in the commodities story has captured investor imagination. The assets under management (AUM) of the exchange-traded commodities (ETCs) of UK-based ETF provider ETF Securities, now stand at US$5.21 billion, up from $2.29 billion in December 2007. This range incorporates 110 different ETCs, including long, short, forward and leveraged versions. But this is still a fairly limited business in the UK for retail investors, who only represent around 5% of invested capital, according to Nick Brooks, London-based head of research at ETF Securities. Across Europe and in the US, these figures are higher - with the US market estimated at about 30%.

Across Europe, ETFs have been a popular means of accessing these markets. Lyxor, the asset management arm of Societe Generale that provides ETFs, has seen huge inflows: its gold bullion ETF alone had $3.36 billion AUM at close of business on May 14 this year. SG itself has a covered warrants business that offers leveraged exposure to different commodity sub-sectors, such as wheat, soya beans, oil and silver. The financial instruments do not offer any capital protection, but maximum losses are fixed in advance at the time of purchase and they are extremely liquid investments.

"Covered warrants are mostly used by retail investors," says Marc El Asmar, London-based head of structured products, sales and marketing, UK and northern Europe at Societe Generale Corporate & Investment Banking. "Usually, these products have a predetermined expiry, but nothing forces the investor to hold it to maturity, because they can resell on the secondary market," he says, although he adds that the usual product lifespan is six months to one year.

Covered warrants illustrate investors' desire to take both a bullish and bearish directional view on a product like corn or soya beans. Naturally, the role of diversification is still an important one for commodities, but even this is becoming more complex. Investors have become savvier about hedging, and it is no longer just a case of protecting themselves against downturns in other asset classes like equity markets or bonds, but seeking shelter from the rising costs of food and fuel, the weak US dollar and high inflation. For the latter, gold and oil have been particularly popular. El Asmar estimates Lyxor's gold bullion ETF has seen inflows to deal with high inflation, as well as diversifying across asset classes. SG's listed gold index protected accelerator actually offers upside if the dollar falls any further.

The food index recently launched by UBS was another example of advanced hedging. It compiled all the edible elements of its Constant Maturity Commodity index, such as wheat, coffee, orange juice and sugar. "This has proved very popular with investors looking to hedge against rising food prices, particularly investors in Asia where food prices make up part of the core inflation measure," explains Morgan Metters, head of commodity index structuring at UBS in London.

The CMCI was the first in a new wave of intelligent indexes that emerged when investors started to realise that broad-based indexes such as the DJ AIG and S&P GSCI were not providing them with the returns that they wanted. The index works by using a range of different maturity futures contracts to avoid the negative roll-yield problem that can bite into investor returns. This would indicate a remarkable degree of sophistication if investors are becoming intimate with the finer points of index methodology, but Metters says that it is more return-driven.

"What investors appreciate about the CMCI is how closely it tracks the underlying market," he says. "The main problem retail investors have is if the price goes up and the returns they receive don't match. This is what was happening with the traditional indexes a few years ago, when roll yield was eating away at their returns."

This is indicative of a growing trend, as investors are becoming more acquainted with the whole investment story; they are developing an understanding of how to exploit a particular commodity curve.

Focusing on the yield curve

"Commodity investors should spend time thinking not only of what specific commodity they like, but also catalysts that will be more beneficial to some parts of the curve than others. We already see people relatively new to commodities getting savvier about what specific investments they want," says Yvonne Handler, vice-president in commodities structured products at Morgan Stanley in London. Handler explains that, in contrast, equity investors have a more static view of the curve. "Equity investors have implicitly taken a view that the futures curve is correct and won't shift as the investment progresses since expectations are already taken into account for the spot, and the forward curve is predicted using dividend and interest-rate assumptions," she says. "For commodities, on the other hand, I like to use a credit bond analogy - a 2010 bond will offer a different return to a 2012 bond because they expose you to different parts of the yield curve."

More sophisticated methods to achieve tailored exposure are coming in varied and accessible forms now that there is established demand for them. JP Morgan's commodity I-Gar has recently been wrapped into a Ucits III fund launched in Ireland, using its Conditional Long-short index. It works by taking the 24 commodities of the S&P GSCI and going long or short on each one depending on how that commodity is performing, with a monthly rebalancing. This dynamic strategy accommodates realities in individual performances.

"Commodities are a wide and diverse universe. Investors may think we are in a bull run for commodities, but in the last year the best and worst performing commodities were up approximately 50% and down 50%, and both of them were base metals, hence the advantage of having a fund that can be both long and short commodities," says Jonathan Kent, London-based executive director in structured investments distributor marketing, UK, Ireland and South Africa at JP Morgan.

These intricacies emphasise that traditional methods are no longer enough to provide the exposure that investors want.

"Irrespective of high headline rates of participation, longer-dated structured products providing exposure to a static basket of commodities could disappoint investors if commodities continue to perform in a diverse way," explains Kent. "While one commodity may perform well, history shows there is every chance that another commodity in the basket will be performing poorly."

The benchmark indexes for the sector, the S&P GSCI and the DJ-AIG, have received criticism for not being able to accommodate these nuances. Subsequently, each has launched their own series of forward versions, but some market participants feel this approach is not right for the complications of today's markets when investors want to be exposed to the entire curve.

"The S&P GSCI and the DJ-AIG have both been in the market for between 18 and 20 years," says one member of a commodity-linked structured products team at a major investment bank. "I would say they were highly relevant when they were designed but there are some very well-known flaws with them."

Volatility

Nonetheless, benchmark commodity index investment serves an important purpose in stabilising markets that can be very susceptible to short-term volatility, owing to fast flows of speculative money in both directions at the higher end of the investment spectrum.

"I don't classify commodity index investment as speculative money," says S&P's Kolts. "That money is stickier and in it for diversification aspects, which is very different to hedge fund money that is much hotter and flows in and out very rapidly." However, this money only has a limited effect on oil markets, he says, estimating it at around only $2 a barrel in oil, owing to the strong fundamentals underpinning price rises.

SG's El Asmar paints the same picture with base metals. "I think the effect is marginal compared to the fundamentals," he says. "One example would be the price of aluminium, which has not experienced the 'same' bull run - if it were purely speculation that was causing the price of commodities to go up, then aluminium would have recorded the same upward amplitude as the others, but it has not because the fundamentals are not as strong as crude oil, for instance."

Smaller markets such as agriculture, though, can be more susceptible. "There are unprecedented levels of cash flowing into agricultural markets accompanied by speculative activity," says Metters of UBS. "The markets don't have the capacity or liquidity of say the crude oil or gold markets to absorb this." He adds that whatever the direction of the markets over the next few years, agricultural markets are especially likely to be associated with high volatility. The S&P GSCI Soybeans Index Total Return, for example, was down 21.98% in March, yet up 8.45% in April.

ETC providers are confident, like ETF Securities' Brooks, that the speculative impact of their products is relatively benign. "In the majority of cases, the flows going into ETFs and ETCs have been miniature compared to the size of the underlying market. As a proportion of daily or monthly trading it is very small." The massive inflows into products such as ETFs, which offer no capital protection, show that retail investors are comfortable with downside risk, even in the face of high volatility.

In the UK market, Meteor Asset Management has just launched a product that offers 100% principal exposure, or to put it another way, zero principal protection as a 'super growth' option. This is an unprecedented move for the distributor, which up until now has always offered some form of principal protection on the varying risk/reward profiles of its commodity products.

At the beginning, pension funds bought the bulk of products and had a greater risk appetite than individual investors, says Graham Devile, London-based managing director at Meteor. But recently, he says, there has been a shift to a 50:50 split between higher and lower risk products. "The more balanced split we have seen of late is probably down to an increased number of individual investors... and those individuals have a lower risk appetite on an individual basis than, say, a pension fund." Nonetheless, he maintains that he will be interested to see what the demand is for the new product offering 100% exposure.

Recent tax changes also have a role to play. "What may be driving the choices that retail investors make is tax treatment, which might encourage the sale of more principal-at-risk products," says a London-based banker. "Also, these markets, and agricultural products, are very volatile and this can make long-term, capital guaranteed structured products expensive to build," he adds.

While it seems that investors have been pushing for protection up until now, commodities could be the market sector that bucks the trend. Provided they remain resilient in the face of speculative activity, commodity markets could become more than just a place to park cash while equity markets recover.

Marc El-Asmar, SG CIB.