Commodities debate: Refining value from raw materials

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RB, Watson Wyatt The first question has to be, given recent price developments, is investing in commodities still a good idea?

FW, PGGM Well, in Q3 2007, we started to analyse our benchmark in commodities. We do this every two to three years, but the main reason was the huge contango [upward sloping forward curve] in the market in 2006. The first question we asked was: "Is commodities still a viable asset class within a multi-asset portfolio?" The second was: "Given an investment in commodities, what should the weighting in energy be?" We were worried about the higher weighting in energy that we had in our benchmark. We were 60% GCI, 40% sub-energy index, so roughly 82% energy exposure. So we set out the reasons why we were invested in commodities. These were, in order of priority: diversification, a hedge against geopolitical risk and – much less important – as a possible inflation hedge. When we did this review in 1999, we used very prudent measures: low expected returns and a very high negative correlation with other assets. This time around we used a zero correlation to other assets and a higher expected return. Even with those different parameters the conclusion was the same: commodities are still a viable asset class for diversification reasons in a multi-asset portfolio. In fact we decided to increase our allocation to commodities from 5% to 7%. And we found that the high energy weighting gives the best diversification within the overall portfolio, so we still have that and we increased our allocation to 7%. So yes, commodities is still a good asset class for diversification reasons.

DM, NFC If by "investing in commodities" you mean "going long commodities", I tend to take a slightly more sceptical view than average. I’ve never been completely persuaded by the diversification argument but I think, seeing today’s geopolitics, that one has to think that commodities have a place in a portfolio as a small allocation. The investors I meet seem to be a little too enthused by the recent returns in commodities and are probably not taking the rigorous approach taken by PGGM. I am deeply concerned by the volume of money flowing into some of these markets. If you see the quality of commentary on some of the events that occurred in March, it was very low, and so I would urge investors to be careful. The flows into some of the agricultural markets is an example: there is a strong possibility people will see substantial retracement on any attempt to liquidate this new open interest. With respect to other types of commodity investment, such as investments in hedge funds or trade commodities or trading strategies, they’ve not had an outstanding last year, but I think the possibilities within that arena are excellent as a source of absolute return, and I think investors must also look at the absolute return possibilities in commodity markets.

BG, Pimco I think there are two issues. One is the flows, and we are coming to that later. The original question was: "Is it still a good idea to invest in commodities?" Defining commodities as investing in some form of long-only exposure, as benchmarked by an index, the answer is: "Yes, it is still a good idea." I am convinced that commodities will provide diversification over a strategic time frame from stocks and bonds. There are a lot of fundamental arguments that say that commodities should – and we have a history of 45 years showing that commodities have – provided that diversification. So with both economic logic and extensive history on our side, yes, for diversification reasons it is still a good idea.

RB, Watson Wyatt So, for diversification, but not necessarily for returns?

BG, Pimco I do not project the actual cash price of commodities, because all of this institutional investment is not in the ownership of commodities, it is in some form of index exposure. And Paul, I’m not referring to the type of activity that you do with your more hedge fund products, I am talking about indices as a measure of the asset class, and those inherent returns include the Keynesian risk premium, they include convenience yield, they include rebalancing, if one chooses to rebalance, all of which are on top of the base return on collateral, and again we have our choice of what collateral that would be. So you ask about projecting returns; I will use history as a guide for those various components of the commodity return and we, of course, need to project what the return of the collateral will be. You add it up and then you reduce that number, because in fact the diversification argument is so strong that even with projecting numbers much lower than historical, you still find that most asset allocation models want more commodities than a chief investment officer would really dare to put into his or her portfolio.

SB, Euromoney How many investors view commodities as an inflation or diversification overlay product and how many are seeking alpha or absolute return?

BG, Pimco The bulk of the $150 billion to $200 billion are looking for diversification and, to a much lesser extent, the inflation protection of the asset class. The money that is looking for absolute returns is either going to be in a totally actively managed hedge fund, or it’s going to be short-term money that says: "I think commodities as an asset class are going up over the next several months." The fact that the money stayed in index funds and with the institutional accounts, even during periods of downturn in commodity and commodity indices, demonstrates that more of the money is looking for those longer-term benefits.

CC, SGCIB Since the commodity asset class is primarily sold on this pitch, we recently decided to revisit our assumptions on commodities concerning diversification, inflation hedging and de-correlation versus stocks and bonds. Our conclusion was that in all cases the argument for commodities still holds. There is still a low correlation to equities even though people were worried about that relationship breaking down locally with, for example, the Chinese stock market falling down in early 2007 and the base metals moving down at the same time. This was mainly due to the fact that industrial metals demand is particularly driven by the Chinese market. Also, since 2002/03, we have experienced a bull market in equities and a bull market in commodities, so one might think that they are highly correlated now, a "market of one". However, SG commodities research conducted advanced analysis using new techniques like dynamic conditional correlation), which shows that correlation is still low, and statistically close to zero. And interestingly it shows the negative correlation strengthening during shocks in the other asset classes. We also conducted an analysis on inflation, as inflation is a big subject today and in the sub-prime crisis aftermath many investors came to commodities as an inflation hedge. The conclusion here was that not all of them are a good hedge against inflation, with the best commodity groups being energy and precious metals. Interestingly, in the case of oil and gold, the relationship has continued to strengthen and there has never been a period of time when oil was not co-integrated with realized inflation. Finally, the question of the return raises the market timing issue and at the moment I would say yes, the timing is still appropriate for a commodity investment.

SW, DCM Since the beginning of the decade, there hasn’t been a period of more than eight months where commodities have underperformed the S&P, so we still view commodities as the leadership asset class compared with bonds or stocks. At big-picture level, we still believe that the environment is one of rebalancing between paper assets and tangible assets, and we’re probably midway through this rebalancing act. In terms of secular trend, the commodity bull market is still in place, based on supply/demand/inventory situations and the monetary side is currently very supportive. Apart from this room, as soon as there’s a 5% correction or 10% correction in the commodity markets, strategists (who never called the onset of this trend) come out with negative calls on commodities or that it is all over. But bull markets climb the wall of worry and end in euphoria. The other point that we’ve been paying attention to over the past eight months is the reflationary environment. Reflation is an environment that we define as an expansion of money supply and negative real rates. This is an environment where commodities as a tangible asset have tended to do well; it’s an environment where there is a faster rate of currency debasement and where commodity performance has tended to be good. This happened in 1998, when the central bank cut the short-term rates after LTCM; it happened after the recession of 2001, the bottom in commodities then happened after 9/11, whereas equities carried on falling for another year, and in this cycle, since September last year, commodities have started to perform strongly on the back of this theme. This has confused a lot of investors who always consider that economic slowdown equates with falling prices. So when paper money loses value, it loses value versus something tangible – such as commodities, which do not have infinite supply. For example, oil has recently had a stronger monetary component – it reacts to the terms of trade. Oil is the Saudi’s currency. Oil is priced in dollars and with the dollar going down because of the credit crisis, they don’t want to lose purchasing power. So they keep their supply tight. 2008 should again be a strong year for commodity returns.

KR, Deutsche Bank Christophe and Bob have talked a lot about the benefits in terms of diversification, and I totally believe in that. At Deutsche Bank the emphasis has been on the macro picture and clearly the major impact here is the integration into the world economy of 2.4 extra billion people with the associated demand pressures. This is the first demand-led commodity boom in my lifetime, rather than a supply disruption price shock. The timescales of infrastructure development are enormously long versus the rapidly growing demands from these extra members of the world economy, and this will drive commodity returns in a way that, in my opinion, won’t subside any time soon. So is it worth doing? Yes, I think commodity returns will still be there. I think we’re in for some bumpy rides in certain commodity sub-classes, as David was mentioning, but overall as a play, yes, it’s still in place. Does it make sense in a portfolio? Absolutely 100% yes.

RB, Watson Wyatt Let’s move over to New York – Eliot, is it still a good idea to invest in commodities?

EG, Jefferies Having the chief architects of each of the S&P GSCI, Dow Jones – AIG and the Reuters/Jefferies CRB Commodity Indexes all as current colleagues now at Jefferies, it would be inconsistent for me to advocate a market-timing approach to commodities. For the long-term strategic investor seeking to obtain the inherent benefits of in the asset class, timing is less of a key consideration than selecting a proper investment format. Given the correlative properties we’ve discussed, provided that there is a return expectation for commodities in excess of the risk-free rate, commodities should be included in any well-diversified portfolio and, increasingly, investors are doing so. As to the investment format, when you discuss an investment in commodities, it is very important to be clear as to the way in which the investment vehicle reflects ownership of commodities, whether active management or passive, formulaic structures, whether futures contracts, equities or physical commodities and a host of other differentiating factors. The manner in which you own commodities significantly affects their investment properties – return profile, correlations, etc. Over the past several years, investors seeking the benefits of the asset class have largely obtained exposure via the leading benchmark commodity indices I mentioned earlier, or enhanced index products tracking the benchmarks but providing for historically superior absolute and risk-adjusted returns. At Jefferies, we are finding that with rising investor sophistication and the proliferation of investment alternatives, investors increasingly are demanding our strategies that provide for both the core benefits of commodity ownership obtained through the beta of the asset class, as well as alpha generated through the oversight of experienced commodity professionals.

PT, Touradji Capital Management I agree with what has been said and would just add that it is clear that commodities have developed into a real asset class for the first time in all of our careers. The natural progression of that is for everyone investing in a more sophisticated way, perhaps with the development of enhanced beta strategies and in ways that attempt to exploit alpha opportunities. So what is the long-term perspective? Sure, I agree with the collective opinion that commodities are a good idea both for diversification as well as the return and alpha opportunities.

RB, Watson Wyatt David, why do you think the diversification argument is less strong than perhaps other people think?

DM, NFC I think it is because I place less emphasis on historical arguments than other people do. And if you ask me over the next year, let’s say, to chart the Dow Jones AIG agricultural sub-index against the Dow Jones industrial average, I think there’s a serious possibility those two could be quite highly correlated with each other because they are both linked with financial flows driven by many of the same things. I would be much keener to look at supply/demand fundamentals and take a view on the market on what’s going to happen in these markets over the next five years. And maybe in common with many people, if you like, with a trading perspective, yes, I’ll admit it, I’m alarmed by the size of flows into some of these markets. I’m alarmed by what people think when they see up and down moves. I say to investors: "When you go long a commodity index, you do know that the statistics, as in the implied volatility of options on these index products, tell you that you’re going to have a 25% drawdown some time in the next three years. You do know that, right?" And not everyone I talk to seems to know that. The GSCI has had two 45% drawdowns and eight 20-something percent drawdowns in the published history of the index.

BG, Pimco How does that compare with equities?

DM, NFC There’s not much in it but the point is that commodity and equity drawdowns used to happen at different times – 9/11 excepted – but I think in future they will be more likely to happen at the same time.

KR, Deutsche Bank These correlations depend on your time frame. If you are looking at horizons of a few months to a year, then there is a weight-of-money argument and it is possible that investment flows will make correlations more positive. But if you look longer term, there are fundamentals that reinforce the negative correlations. One simple linkage that would cause commodities to be negatively correlated with fixed income, for example, is that very often the culprit behind inflation is the price of commodities.

DM, NFC I would agree with you. But if you know there was total investment in long commodity positions of one Google (where a Google is the market cap of Google) a year and a half ago, and if various people think we’re going to have five Googles in short order, what do you think the correlation will be then in a five-Google world?

RB, Watson Wyatt Again I think there are some interesting comments about potential secular issues with changes in underlying dynamics. David makes a good point about considering some of the underlying fundamentals that I think are important. The other point I’d make about correlation is that it moves all over the place.

KR, Deutsche Bank Short term.

Commodity bubble?

RB, Watson Wyatt The next question is whether commodity markets are in a bubble, the next accident waiting to happen?

CC, SGCIB Well of course it was already the question two years ago and look where we are now. Today the big question mark is on how much of the commodity price derives from speculation premium. I would say for oil, perhaps we have a $10 per barrel premium but I would not consider 50% of the current price. It is true that some markets need to adapt to their new price range and I tend to agree with David, for some agricultural products: since the beginning of the year, prices have been limit up or down on several occasions and that obviously indicates increased activity. The one thing that I think is positive for the price evolution is that we have historically high prices in a US recessionary environment. I am wondering what’s going to happen to prices when growth comes back to the market?

KR, Deutsche Bank I think it depends on the commodity. People go on about hedge funds pushing up the price of oil. Well what are they doing? They’re buying futures. What do futures eventually settle into? They settle into physical oil or reference physical oil, and hedge funds don’t buy and store oil. Ultimately the price of oil is the price at which physical transactions are occurring in the market, where people are buying the oil and refining it and selling it to us to put in our cars or heat our homes. So to the extent that it is difficult to store oil and it has to be used, in my opinion although the futures market can get out of sync with the physical market and the shape of the futures curve can be impacted, the answer to the question, ‘are investors really pushing the price of oil?’, is, in my view, no. There are perfectly adequate reasons to explain why there are higher oil prices in dollar terms. Are investors moving the price of gold? Absolutely definitely. What else do you use it for? The amount of gold that’s used in industrial usage is tiny compared with the investment flows, and it’s incredibly easy to store. In the middle, in base metals and ags, there is a grey area. Ultimately though, unless they can store and hoard, investors can’t push the price of the physical.

RB, Watson Wyatt David’s shaking his head.

DM, NFC Well, I don’t really allow people to say things like ‘hedge funds are buying oil’ without pointing out that by my best estimates there’s been no solid evidence of net buying of oil by hedge funds over the past year and a half, so since they’re not doing it, we should stop pointing fingers at them. And then you’re saying that even if they are doing it, they can’t have a big impact on oil because everything settles to physical. And that seems to be a very big debate. I have to say the continued flows of fresh open interest seem, to me at least, to be pushing the equilibrium price higher and to be a model where people are prepared to effectively pay others to store their commodity.

KR, Deutsche Bank When I said hedge funds, I was being sloppy: that’s short-hand for investors.

SW, DCM My question mark would only be how investment flows in the billions affect an annual production of $6 trillion to $8 trillion? CFTC has recently come out with a report saying that hedge funds or pension funds are not responsible for pushing agricultural prices, for example. Many commodities that don’t trade on a futures exchange, such as phosphates, ocean freight, sunflower oil, thermal coal or minor metals, have also seen escalating prices. Again, the attack on a minority is way too easy. Many markets have derivatives positions trading as a multiple of the underlying. In commodities, the open positions on contracts still trade as a fraction of the underlying. Finally, let’s not forget that, in a market economy, prices are a signal and higher prices are here to encourage, stimulate a much needed supply response in a world of growing demand. Higher prices are here to incentivize the entrepreneur, the producers to extract more stuff.

KR, Deutsche Bank Exactly. People talk about the amount that’s invested in commodity indices, and Bob and maybe people around this table have a better idea than me, but it is of the order of, I’ve heard various numbers from $150 billion to $200 billion or possibly more, but it’s a fraction of the global turnover of commodities markets. It’s the tail, it’s not the dog, depending on the commodity. Clearly in precious metals it is very, very significant.

BG, Pimco To have a speculative bubble in any asset you need one or both of two conditions. First, you need a constraint on supply. If there’s plenty of supply, then you cannot drive prices up. We have seen real estate boom because there’s a limited amount of it. Second, to have a speculative bubble you need to lose any measure of intrinsic value. We saw dotcoms in a bubble because nobody knew what they were worth. Remember that none of these commodity investors, whether it’s the long-only investors or even most hedge funds, certainly the CTAs, owns physical commodities. Pimco is one of the largest managers of assets benchmarked to commodity indices but it does not own or consume one bushel, barrel or pound of any of these commodities. More than that, typically we are not even in the front month of the commodity. Therefore, how can we be causing the real world to drive up prices when we are not adding to the demand out in the real world? What we are buying is commodity futures, which, for all practical purposes, are in unlimited supply. And, furthermore, once we have established an initial position – and, as Stephan notes, that flow of new long-only money is not that great compared with the overall volume in the markets – then as we roll our positions, we are simultaneously selling and buying. How can you drive up prices if you are both selling and buying the same commodity? Yes, what goes on in these markets, in futures markets, has information value that affects perceptions in the cash markets, but at the end of the day can we take price levels up to higher than they would otherwise be?

In the meantime, we will have more volatility as these flows go in and out, mainly from the hedge funds.

KR, Deutsche Bank Exactly. Through what mechanism are people buying futures driving up the price of oil – the cash price of oil? People who are buying the physical have to refine it and have to sell it to you to consume, it’s a consumable product. That’s the difference between a commodity and financials. Financials are not consumed.

DM, NFC Right now we’re going through a period where there’s new open interest arriving in the market every day of new, if you like, first-time buyers coming into the commodity market. I personally think that that is playing an enormous role. On the other side of the argument, though, I’ve recently been looking at such markets as cement and iron ore and rice, where there’s absolutely no investor interest, and they’re similarly on the rise, which suggests something fundamental is at work.

PT, Touradji Capital Management It seems as if, both in this room as well as in the broader market, the dialogue has become that you must either believe that commodities are in a bubble or you must believe that you have to be fully invested now. I don’t see the need to put myself in either one of those camps. Why must it be that binary? If I ask the question: "Do you think equities in the long term are a good asset class?", I would imagine that all of us would answer yes. Since 1981, equities have been in a bull market, so for close to three decades being invested in equities has been a very good idea for a long-term view. However, the third quarter of 1987 was not nearly as good a period of time to be heavily invested in equities as other times. Similarly, Q1 ’00 would have been a poor time to be heavily investing in equities, whereas Q1 ’03 would have been a great time. And so on. So do I think commodities are in the long run, for both return and diversification purposes, a good idea? Yes. However, could it be that in the second quarter of 2008 this is one of the poorer times to enter new investment in commodities? My personal opinion is yes. Let’s take aluminium as an example. It has generally been rising in price for the last few years and had one invested in aluminium two or three months ago, one would be up about 25%, which on an annualized basis is a great return. Had one invested in aluminium in May of ’06, one would be down 10%. Even for long-term investors, market timing in this kind of environment can have a profound effect on annualized returns for the next five, 10 years. My answer to whether we’re in a bubble or not is that it is the wrong question to ask.

EG, Jefferies Investors should now be positioning themselves to capitalize on the realities of present-day commodity markets. Given the ongoing evolution of the commodity markets – the increasing volatility, size of the investor base, number of product offerings, the very rules by which commodity futures are traded on exchanges – the way in which investors approach commodities today should be fundamentally different from the way in which they have done so previously. The sophisticated investor is increasingly pursuing techniques alternate to those which were unveiled in the early 1990s or in the late 1990s or even several years ago. Not to say that investors are reducing core strategic exposure to the asset class but, in re-evaluating their position in the marketplace, investors are transitioning exposure to dynamic strategies that can generate performance, irrespective of the next directional price move.

FW, PGGM The strategic standpoint is, for our fund, the most important longer-term decision. When running the portfolio I do look at shorter-term outperformance, but that can never overshadow the longer-term view. So as Eliot said correctly, I will never take off my commodity exposure, I will never sell out of energy because I think oil is due for a correction.

The trouble with indices

RB, Watson Wyatt Frans, you started off in passive or quasi-passive strategies, perhaps you could just discuss a little about how you think about implementation of commodity strategies.

FW, PGGM Let me start off then by answering the question, is there a right index? I don’t think there is, it depends on why you are investing and what your goal is. When we looked at our new benchmark we naturally looked at different indices – we were benchmarked against the S&P GSCI – and we quickly came to the conclusion that we wanted a simple and transparent index. And it had to be a general index that could achieve our goals within the next five or 10 years. So in that sense there’s no real correct index. We looked at S&P GSCI, Dow Jones AIG and the Reuters/Jefferies CRB Index and decided to stick with the S&P GSCI methodology for rolls in the front months on most commodities, especially in the energies, which gives us a better hedge against the geopolitical risk. We also invest in sub-indices and adjust the weights ourselves to tailor the benchmark to what we were trying to achieve. So we’re now benchmarked against 80% petroleum index, and we took out natural gas, so the S&P GSCI wasn’t the right index for us, because it involved natural gas. This is not because we don’t believe in natural gas as an investment, but the way it’s constructed in the index it’s not giving the returns that we were looking for, and we weren’t allowed, or we weren’t allowing ourselves to put an alternative trade for natural gas in the benchmark, so we left that up to the investment manager who is now happily investing that in alpha.

If I look at alpha versus beta, we started off in 2000, we were purely passive, the whole €3 billion that we had invested at that time was benchmarked against the GCI. The current book is roughly $9 billion, and 85% is invested via total return swaps, 15% is invested via futures, where we no longer replicate indices, we’re rolling differently, we’re putting on different weights, so we see that as an alternative investment as well. And if I look at the total return swaps that we have, roughly 30% is via enhanced products. But it all stems from a long-only perspective. Since the beginning of this year we’ve added commodity alpha as well, but that is relatively small and that will never be allowed to be so big that it will overshadow the beta component, because that is the single most important thing in our portfolio.

RB, Watson Wyatt David, I think you’ve been rather sceptical about some of the long-only index strategies. Is that still your view or has that changed?

DM, NFC Well, I think there are interesting things to do in commodities and not so interesting things to do in commodities. We all understand there’s a huge distinction between hedge fund investing and investing in long-only products. In the long-only side my particular bête noire are the bank-issued enhanced index products, which I think are substantially terrible products and constructed based on history and liable to fail because of the risk that whatever trick it is they’re doing to beat an index will, after a period of time, stop working. And also I will make the following note: in equities people underperforming indices is quite common. Well you’ve got to say there’s something pretty weird about the commodities asset class when just about everyone does beat their chosen index. So either I’ve lots of very clever friends, or these are really stupid indices. I think the latter actually.

SB, Euromoney What’s wrong with them?

DM, NFC What’s wrong with them is that they can be gamed. This market is beset by people who have equity analogy disease. People who see vanilla commodity index investments as cheap because, well, on those terms, that would be cheap in the equity market. Or people who just jump to conclusions that a vanilla indexed product is the best way to access, if you like, commodity beta, because I think the argument in equities has been well and truly won by people who do regard vanilla indexed products as good ways to acquire equity beta, but those analogies stop working in commodities, because an investment in the S&P GSCI or Dow Jones AIG or Roger’s index or whatever, is not so much a passive investment as an investment programme because of the need to roll your futures positions and manage your cash and do all those other things. I’d much rather call those systematic investment vehicles than indices, just because you have to have a set of rules and you’ve got to figure out whether they are good rules or bad rules and what all those rules mean. There’s nothing passive about the S&P GSCI, it’s a trading programme.

KR, Deutsche Bank But on the other hand, there’s nothing passive about most equity indices, right? Even the ones that are considered to be real beta have all sorts of filters and rules about which stocks are allowed in and which stocks are taken out. And actually we did some analysis at Deutsche Bank and if you tweak the rules of the S&P500 you get radically different performances over time. If you stick with the S&P500 as was back in the mid 80s, you get very different performances over the bull and bear markets, the equity sell-off in ’87 and the sell-off in 2000. So every index is effectively an investment programme.

DM, NFC I accept your point, but I think there’s an investor perception that these indices are far more passive than they are.

KR, Deutsche Bank Let’s put it this way, the detailed decisions about the rules are extremely influential on the returns of the index.

DM, NFC But the fact that 70% or 80% of the guys I track who are trying to beat these indices do beat them, that is to me canonical, that is absolutely central. That piece of information should change the way you think.

SW, DCM There is also the fact that indices are non-leveraged, so they have to be compared on a non-leveraged basis in terms of investment. A lot of active managers use leverage to beat the indices. Then it’s like every asset class, you have active strategy and passive strategy, and there are times where passive strategies tend to do better – in the trends usually – and a time – when in consolidation or correction – passive strategies tend to do less well, and the active strategy can outperform the index during those phases. Index strategies are totally appropriate to capture what the asset class has to offer (diversification, inflation protection and returns) in a transparent and cost efficient way.

DM, NFC I’m talking about active funds that run long-only positions with the indices that they benchmark, or with an eye to the index that they benchmark. The fact is that a layer of discretionary management seems to improve performance.

KR, Deutsche Bank Suspiciously often.

DM, NFC Suspiciously often, yes. Well the suspicion, by the way, is not of malfeasance, but rather that this market is a bit different to what investors assume.

FW, PGGM The tools that you have to outperform that benchmark are way greater than in an equity market.

DM, NFC I think you’ve got term structures, you’ve got to execute rolls, you have a choice of alternative future contracts.

FW, PGGM Exactly, yes.

BG, Pimco Let me suggest that the public indices can still be used as a benchmark for the returns of the asset class. Yes, there are ways, structural and otherwise, to outperform those indices, but unless you have an absolute return strategy, like some hedge funds, then you do have an eye on tracking error versus the index while still trying to consistently outperform. In equityland, fundamental indexation in fact is, or at least has been shown to be, superior to cap-weighted indices. That’s a structural aspect, and in commodities you can draw that analogy that there are structural things that are better than the plain vanilla indices, but yet those plain vanilla indices can be a measure of the asset class.

DM, NFC I completely agree with you. I think the plain vanilla indices should be a measure of how well long-only funds are doing. Absolutely, I think what Frans is doing in defining a fairly vanilla index as his benchmark is absolutely the right thing to do, but unlike in equities, where you might expect an outperformance of zero, I think you should have a somewhat more aggressive expectation of outperformance. If you put a layer of intelligent discretionary management on top of a vanilla index, you should expect to see people do better.

BG, Pimco Yes. The index is a reasonable benchmark but one that we should expect to outperform.

DM, NFC And then it gets interesting when you ask how much outperformance should you expect? What kind of information ratios should you expect if you got a tracking error objective of X? Where should you expect the information ratio, Y over X, to turn out. And it seems to me that the information ratio in these markets that’s available to investors is very attractive compared with that in other markets. That is merely saying that it looks like, for given amount of risk versus the index, you can do rather better than you can with that same amount of risk in equities or bonds.

KR, Deutsche Bank You have to look at the way the rules work to make the index perform. And there’s no hard-and-fast way of doing it, there isn’t a hard-and-fast way in commodities, and there isn’t in equities, as I mentioned earlier, so you have a decision to make. I think there are ways of constructing indices that can enhance returns where the rule that you use is extremely transparent and sensible and based on economic sense, and there are ways you can do it that are basically just backtested. And there are a spectrum of these things, but I think it’s perfectly legitimate, depending on what the index is going to be used for. I think excessive backtesting is wrong, but trying to have rules that have some economic basis, given the fact you have to have rules anyway to construct indices, I think is perfectly legitimate.

CC, SGCIB Maybe bridging between Kevin and David, yes, the enhanced index technology can really make sense and match an investment prospect that each investor will have in mind. I agree with David on one important point, as I think that investors have discovered through indices that a commodity index translates a trading strategy. If you want to get long commodities, you need to do something every month as the first nearby future contract expires, so either you set up a trading floor or you passively invest in an index that will do it for you. We all witnessed that some indices were not well adapted in 2006 with the contango on oil curve, and they have proven to be more suited a year later. I would tend to think that there is no absolute index on commodities because you would need one that makes money all the time.

EG, Jefferies I think the points that have been raised are excellent ones in that it is important to differentiate between a benchmark and a product. For investors that have neither the mandate nor inclination to accept tracking error in commodities, the benchmark becomes a default product. The next progression of investment alternative would some sort of rules-based, formulaic enhancements to an index in an attempt to generate increased return. These enhanced indices are at their core fixed, rules-based, algorithmic expressions of trade ideas. However, as we know, no single passive investment strategy will be successful at all times, in all market conditions, irrespective of unknown market developments. This is why investors have often adopted a portfolio of enhanced indices, utilizing a range of embedded techniques, as an attempt to essentially simulate trading accounts in a transparent format. Again, with the increasing volatility and expanding range of opportunities in the marketplace, investors are wisely shifting the onus of trade construction to commodity professionals via asset management products that alternate allocations between strategies on a tactical basis, providing for strategies that may be most suitable for the specific dynamics of the market at any given time and capitalizing on more short-term dislocations while maintaining continuous, uninterrupted beta exposure.

Strategies for success

RB, Watson Wyatt So Paul, as a hedge fund manager, how do you view active and passive investment strategies, since this definition of passive is a bundle of strategies that attempts to simulate, at least in part, the tactical decisions of an active trader?

PT, Touradji Capital Management By passive, we do not mean vanilla indices. On the passive side, we’re only interested in enhanced outperformance products. So last year, we outperformed our benchmarks by over 1,300 basis points. We actually believe that if we can consistently outperform by 400 basis points or more over time we will be a top percentile product. But as important as the outperformance is how you get it. If it’s with leverage or taking a lot of tracking error, I don’t think that that’s a really attractive index product. We were very careful in the manner in which we constructed our enhanced index, there were very tight parameters as to how much we could trade per individual commodity, how much we could trade per commodity sector, and how much we could trade overall on both net and gross exposure. As much as I’m proud of outperforming by 1,300 basis points, I’m even prouder that we did it taking less than benchmark weights, ie, our net and gross were less than 100% and yet we strongly outperformed in a year that had a strongly rising market. I guess the manner in which we did it reflects the same success we had on the pure alpha side; we had a pretty good year in our hedge fund, where again we had a leverage of less than two times, which is about a quarter or a fifth of the industry average. We were completely market-neutral, which is what we’ve chosen to be for the last year and a half, and we had great return opportunities. So we believe that there’s a lot of opportunity in this asset class now. The weight of money is certainly creating disequilibrium and alpha opportunities, whether it’s trading one commodity versus another, or tactically trading the commodity indices and sub-indices.

EG, Jefferies With shifting global trends unlocking value in commodity markets, significant opportunities have been created for those positioned to capitalize. The experienced player in this market environment is reaping the benefits of having participated in the commodity markets through multiple business cycles previously. This contrasts to a number of new managers now attempting to apply strategies historically utilized in other asset classes to commodities, who as David said, are facing significant difficulties in that transition.

RB, Watson Wyatt So which strategies are being employed?

BG, Pimco Let me start with types of active management. And here again, I’m going to take as a base not the absolute return strategies of people that go both long and short, that is, the classic hedge fund. Rather someone who invests primarily because they want the inherent returns of the asset class. Achieving those returns means capturing certain risk premia, certain characteristics of the asset class. Now, let’s go one step further. There are other risk premia not necessarily captured by the plain vanilla indices that you use as a benchmark; there are certain structural aspects of these markets that you can use to make money versus the published indices, while still tracking the inherent asset class that was the reason you put your money in there in the first place. We call all of this structural alpha strategies. Then you can go one step further and begin to predict movements of individual commodities or sectors by overweighting and underweighting, while still thinking about tracking error versus your index. That becomes a bit harder because now, instead of just dealing with the risk premium, you’re saying that if you want to underweight copper and overweight corn, that you know more about the copper market than all those other people that trade copper futures, and simultaneously you know more about the corn market than all those people that do nothing but trade corn futures. Some people are good at it, especially if they focus on just the handful of commodities where they may have an informal advantage. I think one person in this conversation has a record of being good at that sort of thing. But that is another level of active management beyond just capturing more risk premia and more structural elements.

KR, Deutsche Bank One thing to point out is that active strategies are a pretty tough sell when most passive indices have been returning double-digit returns for five years. And commodities are extremely volatile, which makes investors wary of active management.

SW, DCM That’s why portfolio construction is important, because there is low inter-correlation between commodities and that takes down the volatility. However, it’s also what makes the index appealing.

RB, Watson Wyatt What about commodity-linked structured notes?

CC, SGCIB They are fashionable today for two main reasons: first, after the sub-prime crisis investors are looking for real asset underlyings and commodities are particularly meeting this characteristic; second, these products often offer a capital guarantee that is particularly looked for in this type of general market environment. As a consequence of the sub-prime crisis, we at Société Générale have seen a significant amount of cashflow in commodities, starting in September, and from all types of investors, retail, distribution, private banks, institutional, and a true acceleration of incoming flows.

What next?

RB, Watson Wyatt So finally, can I ask what you all see happening in the asset class in the next 12 months?

EG, Jefferies The global credit conflagration illustrates well the impact that short-term drivers can have on the asset class. While commodities are frequently referenced as a negatively correlated asset class, we witnessed at the end of March and beginning of April 2008 a uniform increase in volatility across markets – equities, fixed income, currency, commodities, etc. These short-term effects represent tactical opportunities to investors. As a more long-term observation, the tremendous rally in the price of diversified commodity indices in the second half of 2007 and the exceptional return year to date in 2008 highlight the substantial returns potentially available to the beta holders of commodities in a negative returning equity environment, precisely the non-correlated diversification that commodity investors seek.

BG, Pimco I would just note, as we discussed before, that increasing margin requirements and so limiting access to futures will not drive up physical prices. One should distinguish between the futures market and the cash markets. Lack of liquidity in futures does not have a direct impact on supply/demand/inventories in the cash markets.

KR, Deutsche Bank Where I’ve been spending a lot of time and effort is in the carbon markets. I think in five, 10 years’ time, carbon is going to be a store or means of transmitting value throughout the world in the various local trading schemes. It’s very heavily regulated; it’s a choppy, difficult market to get involved in; but it’s also the source of some of the biggest relative value plays in the financial markets at the moment on a percentage basis, and I think that is a huge source of growth over the next few years.

RB, Watson Wyatt What about polythene, cement – more esoteric things?

DM, NFC Yes, I think the petrochemicals are right in there, I think ethanol is in there.

KR, Deutsche Bank Ethanol I think definitely, yes.

DM, NFC There’s about 20 of them, there’s a big bunch of things, obviously iron ore, steel...

KR, Deutsche Bank Rice, minor metals, where we’re seeing hedge funds doing OTC deals on minor metals, cobalt and things like that.

SB, Euromoney Well, that is all we have time for. Thank you all very much.