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By David Stevenson –
Over the last decade commodity trackers have literally come from nowhere to emerge as the next BIG thing in the world of alternative assets. But that huge success has also thrust the humble commodity index into the spotlight – many investors still struggle to understand why the main index families are so radically different (with exposure to energy being the key differentiator) or how futures-based structures can cope with the long-term effect of the roll yield.
That debate has prompted many investors to demand better indices, and a small but hardy bunch of ETP pioneers has reacted by dabbling around with what are in effect next-generation indices, mostly as a way of liberating asset class returns from the prison of contango and backwardation.
ETF Securities, for instance, has decided to focus its fire on using 1, 3 and 6-month forward contracts whilst outfits like iShares and db X-trackers, by contrast, have looked to ‘optimise’ widely used indices to iron out the negative effects of the roll yield.
One of the more radical approaches to this challenge of optimisation has come from Lyxor and its Lyxor ETF Broad Commodities Optimix TR (OPTM). This systematic long-only strategy is based on a predefined rolling methodology which involves selecting from a range of 24 commodities the best contracts to roll (i.e. the ones that generate the most advantageous roll yield) taking into account such factors as the shape of the curve, the seasonality, or historical patterns.
This innovation is, of course, hugely welcome, but my guess is that it’s not enough. Commodities ETP structurers need to learn something from the ‘smart beta’ revolution. Let’s be honest, smart beta trackers have a very different objective in mind than just optimising futures curves – smart beta advocates look to fundamentally tilt the returns of a whole asset class towards a particular ‘style’, be it dividends, lower volatility (defensive), equal weighting (in effect harvesting the small-cap phenomenon), or just plain old momentum.
Over the last 12 months or so, ETP issuers have started quietly nibbling away at these style tilts with quirky twists on the smart beta theme using commodities. Lyxor, for instance, already has its momentum fund, the Lyxor ETF Broad Commodities Momentum (MOMT), which looks to harness momentum trends in a systematic long/short strategy based on pure quantitative signals. The underlying index ranks commodities according to a technical trend indicator, which is, in turn, based on the shape of the futures curve.
Source has also partly attempted to muscle in on this space with its LGIM Commodity Composite Source ETF (LGCU), which tracks a specialist index designed by Legal & General Investment Management that focuses on at least three sub indices but weights these commodity baskets on an equal-weighted basis quarterly.
Now Ossiam – something of a smart beta specialist – has stuck its oar in with a full-bodied smart beta commodity tracker, the Ossiam Risk Weighted Enhanced Commodity ex. Grains TR UCITS ETF (CRWU). You can see our news story here: Ossiam launches world’s first smart beta risk-weighted commodity ETF.
Key features of this ETF:
- Diversified basket of 20 commodities including metals, industrials, energy and agriculture ex grains (grains have deliberately been excluded on ethical grounds). Crucially, the index is constructed in such a way that it avoids concentration on oil.
- Allocates no more than 33% to any one commodity sector.
- Weights commodity components in inverse proportion to their realised volatility (i.e. the volatility of the futures commodity futures price), rebalanced on a monthly basis.
- Mechanism to mitigate contango by owning contracts for a given commodity that create the least negative roll yield.
- Long only.
And all this for just 0.45% per annum!
Full marks to Ossiam for addressing what I think is the elephant in the room amongst cautious, mainstream equity and bond-focused investors suffering from commodity-phobia – that taming the futures curve by optimisation only addresses one core concern. The bigger challenge is working out which of the key baskets or sub indices we want to actually invest our money in at one point in time!
At the heart of this latter and, in my opinion, more important challenge is that not all commodities are created equally. And, equally importantly, they don’t all respond in the same way to broad economic cycles. Should I be long gold now and short energy, or vice versa etc?
Over the last few years any number of commodity critics have rightly pointed out that correlations between key baskets such as energy, precious metals and industrial metals have shot up, but this correlation has now started to drift away again. This growing dispersion of returns makes complete sense, of course. There’s no intrinsic reason why gold and oil for example should move in the same way, whilst many agricultural commodities seem to have their own weather and storage-related cycles.
If we dig a bit deeper it becomes obvious that not all commodities are as volatile as each other, nor for that matter likely to be super charged by growth in China. Oil, for instance, has a strong correlation with geopolitics and supply constraints in key OPEC countries, whereas industrial metals and especially copper is clearly a surrogate for Chinese building starts. The point though is that we should expect dispersion of returns within this ‘super sector’ and that is what we are now getting. Crucially, many investors want to reduce volatility and focus instead on those commodity baskets with lower ‘perceived’ risk whilst other investors, aping the methodology behind Lyxor’s momentum fund, want to capture key trends using momentum as a key indicator.
The Ossiam ETF is I think especially noteworthy because it’s designed to appeal to the more defensive asset class allocator, who is instinctively worried about the volatility of, say, energy prices due to geopolitical concerns. In truth, many conventional fund managers and wealth advisors would not even dream of investing their clients’ money in the commodity sector precisely because they think that the whole spectrum is massively ‘risky’ and volatile…or at least that’s what their clients say to them!
But now that Ossiam has introduced smart beta into the equation, I think we could see even more radical ideas emerge. For instance, specialist research house Parala Capital, on whose advisory panel I sit, has started playing around with a really rather bold idea, namely linking the selection of a particular commodity sub index to broad macro economic indicators and signals i.e. a key economic trend is likely to have very particular effects on a particular commodity basket. This approach effectively puts the business cycle and possibly even the risk-on, risk-off cycle back into commodity investing – an essential first step for many investors worried about the inherent complexity of the commodity super sector. Harnessing these macro signals and then maybe marrying them to momentum-based indicators and risk-weighted structures (lowering risk budgets) might be the magic bullet for many mainstream investors, encouraging them to dip their toe into the world of commodities but without having to rely on expensive and, frankly, unreliable hedge funds and CTAs.