By John Kemp/London
Commodities were the worst performing asset class for the third year running in 2014.
Investors, including some of the world’s largest pension funds, have seen billions of
dollars of wealth disappear as a result of investing in commodity index products over the
last decade.
So it is essential to understand what went wrong to help prevent a similar problem
recurring in future.
“Facts and fantasies about commodity futures,” first published in 2004 by Gary Gorton and
Geert Rouwenhorst, proved one of the most influential research papers in 21st century
finance.
It provided the intellectual underpinning for the investment boom in commodity derivatives
which followed over the next eight years until roughly 2012.
Gorton and Rouwenhorst concluded “the risk premium on commodity futures is essentially the
same as equities” and better than bonds.
“In addition to offering high returns, the historical risk of an investment in commodity
futures has been relatively low” and “they are an attractive asset class to diversify
traditional portfolios of stocks and bonds.” Yet all of those propositions have come under
scrutiny as returns on commodity index products have disappointed investors over the last
three years and in some cases longer.
Several high-profile investors and commodity index fund operators have recently closed
down their operations citing returns which failed to match the complexity and risk
involved in running the programmes.
“Facts and fantasies” was based on an analysis of returns that would have been available
to an investor in an equally-weighted index of commodity futures fully collateralised by
US Treasury bonds between July 1959 and March 2004 (NBER Working Paper 10595).
“Facts and fantasies,” and similar papers written later by others, played a pivotal role
popularising investment in commodities and making commodity indices respectable for a much
wider group of investors. Previously, commodity investment was the preserve of investors
and hedge funds with a high appetite for risk and willingness to endure volatility.
“Facts and fantasies” helped convince even conservative investors, such as pension funds,
that commodity derivatives, especially indices, were a prudent addition to their
portfolios.
Commodity derivatives were not just a directional bet on boom-bust but an “asset class”
that could be a source of long-term returns across the business cycle.
Initially, the performance of commodity indices was in line with the historical research,
and even exceeded expectations. Commodity indices soared between early 2002 and July 2008.
Hit-hard when the global financial crisis intensified in third quarter of 2008, they
staged a moderate comeback in 2009, 2010 and 2011. Since then, however, performance has
been consistently disappointing. Between June 2004 and June 2014, the compound annual
growth rate (CAGR) for the S&P Goldman Sachs Commodity Index (GSCI) was -1.8%. The Light
Energy and Non-Energy versions of the GSCI performed little better, eking out meagre
returns of +1% and +2% per year respectively.
By Dec 23, however, returns on the GSCI averaged -3.7% per year since the middle of 2004,
-1.3% for the Light Energy version, and just +1.2% for the Non-Energy variant.
Returns have been poor compared with stocks. The S&P 500 equity index achieved total
returns of around +7% per year between June 2004 and June 2014, increasing to about +7.9%
by December 2014. In practice, commodity derivatives have exhibited all of the volatility
of other asset classes (and often more) but none of the returns.
The most widely invested commodity indices were the two families known originally as the
GSCI and the Dow Jones AIG index. Both have changed ownership and been rebranded over time
and are now controlled by Dow Jones S&P Indices and Bloombeg Indexes respectively.
None of the most commonly tracked benchmarks is an exact replica of the equal-weighted
basket of commodity futures analysed by Gorton and Rouwenhorst between 1959 and 2004. For
all sorts of reasons, not least the small scale of some futures contracts, it is difficult
to exactly replicate the “Facts and fantasies” type index as an investable index in the
real world. Most index families, but especially the main GSCI, are heavily weighted
towards petroleum futures (crude oil, gasoline and distillate fuel oil), which tends to
limit their diversification.
But the fact most commodity indices have produced similarly disappointing returns since
2004, including variants with a much lighter weighting towards crude oil and refined
fuels, suggests index composition and the process for rolling maturing contracts forward
on its own cannot explain the poor performance.
There is a tendency in the financial services industry to celebrate successful products
and try to quickly forget the unsuccessful ones: why dwell on the failures of the past?
The basic explanations for the poor performance of the indices can be recounted easily
enough. Index returns comprise three components: (1) the spot price of the commodity; (2)
the yield from the Treasury securities used as collateral; and (3) the roll return from
swapping a position in maturing contracts into longer dated ones.
l John Kemp is a Reuters market analyst. The views expressed are his own.