Indexology^® Blog

If you experience your most expensive 4th of July ever, it may be from the unprecedented shortages of commodities in June.  Since 1970, as far back as the S&P GSCI has data, there has never been a June with as many commodities in backwardation as in June 2014.

Of 24 commodities in the S&P GSCI, 23 of which are in the DJCI, 12 are in backwardation (as defined by the monthly excess return less the monthly spot return): Brent Crude, Cocoa, Copper, Corn, Cotton, WTI Crude Oil, Feeder Cattle, Gold, Live Cattle, Natural Gas, Soybeans and Unleaded Gasoline.  16 commodities are the most that were ever in backwardation together during any month in history. That happened 3 times: in March 2004, Jan 2004, and Dec 2002.  Also, the last time there were more than 12 commodities in backwardation was before the global financial crisis, back in May 2008, when there were 13 commodities in backwardation.

The average number of commodities in backwardation per month since 2002 when all 24 commodities were included in the index is 8. In 2014 through June, it has been 11 per month on average. We have not seen this since 2004 when the average was also 11 per month – the total return that year was 17.3%.

Last, notice in the chart below that going all the way back to 1970, there are some months that never saw 12 or more commodities in backwardation.  Never has a Feb, Apr, Aug or Nov seen a count this high, and in 2014, June makes it’s first appearance in the list.

The saying goes, “if the only tool you have is a hammer, everything looks like a nail.”  That is the difficulty Fed chair Janet Yellen sees in monetary policy: if the only tool is raising or lowering interest rates, then everything – bubbles, inflation, unemployment, excessive risks, yield hunting or systemically important financial institutions – looks like nails.  In a lecture at the IMF earlier this week (here), Mrs. Yellen answered questions about future bubbles and rate increases by explaining that the Fed has much more than the hammer of interest rates.

Macroprudential policy may not get through most spell checkers, but it is the chosen approach to frothy financial markets and incipient bubbles.  Macroprudential policies are not new, but most were not aggressively used in the run-up to the financial crisis. Examples include regulatory limits on leverage, restrictions on short term funding and stronger underwriting standards for loans and mortgages. When the challenges in the financial markets are rapidly rising home prices or excessive and misunderstood risks, the response should be tighter credit standards for mortgages or restrictions on leverage.  If the Fed were to raise interest rates to burst a housing bubble, the bubble might persist while higher interest rates boosted unemployment or lowered economic growth.  Restrictions on loan-to-value and income-to-loan ratios would be a better choice.  Interest rate policy should be reserved for controlling inflation and unemployment.

The chart shows the monthly pattern of home prices (as measured by the S&P/Case-Shiller 10 City Composite Index) and the fed funds rate since 1987.   While whether the fed funds rate aggravated the housing bubble is debatable, there is a need for better ways to address bubbles,

The combined use of interest rate and macroprudential policies has some implications for investors: First, worries about a renewed housing bubble are not likely to push the Fed to raise interest rates. Those who want to argue that the rate increase will come sooner than the consensus target of the summer of 2015 need to argue about inflation and unemployment. Second, macroprudential policies are likely to reduce risks and profits in the financial sector. Less leverage should reduce the risk of another Lehman Brothers scale bank failure; it will also lower bank profits.

Some may wonder why macroprudential policy rules are needed – shouldn’t market discipline keep leverage in line and maintain credit standards?  Hyman Minsky, a sometimes forgotten economist, noted that when good times persist people forget the risks and ignore the rules until the bubbles grow, leverage expands and banks and businesses fail.  Macroprudential policy is partially an effort to control human nature.

Recent financial crises have exposed the shortcomings of the traditional approach to asset allocation and have led an emerging shift, especially among institutional investors, towards dynamic asset allocation, hinged on the diversification across risk factors. While there are numerous research papers that explore this topic, they tend to be theoretical and it is for this reason we have written a research paper which has a stronger focus on the practical aspects of implementation. (Click here to access the paper)

Key Stages of Decision Making and Implementation

Necessary Considerations prior to adopting alternate beta strategies in asset allocation

• The adoption of alternate beta strategies is often related to the investment philosophy of an organization and whether it subscribes to the belief that long term risk premia can be harvested to achieve long-term returns.
• Investors may adopt alternate beta strategies because of their investment objectives and constraints.
• Are there the commitment and the expertise inside the company to ensure successful implementation?

How to ensure successful implementation?

• Choose the right mix of factors, in order to achieve investment objectives and meet constraints.
• Evaluate the diverse offering in the marketplace and choose appropriate strategies and a skilful manager
• Understand  the secondary exposures of alternate beta strategies
• Assess the costs of implementation (direct costs, such as commissions, and indirect costs, such as implementation shortfall and portfolio turnover)
• Measure and monitor performance on an ongoing basis.

There could be no more symbolic time than just before the July 4th holiday for S&P Dow Jones Indices (S&P DJI) to announce the Dow Jones Commodity Index (DJCI), an alternative to the former DJ-UBS. This is the first ever commodity index under the Dow Jones brand to be fully free from conflicts of interest, plus it highlights diversification and liquidity as its intrinsic characteristics.

Please see the table below summarizing the key differences between the DJCI and former DJ-UBS:

What is most important about the table above? The commodity selection.  Nothing is more important about a commodity index than what commodities get included. The DJCI is run by S&P DJI with nearly two decades of proven commodity indexing experience built upon transparent decision making, strong governance, and critical quality controls. This experience is poured into the DJCI; including commodity selection based on the rules written in the methodology that mirror the time-tested rules of the S&P GSCI methodology.

The DJCI is governed by the Commodity Index Committee at S&P DJI made from members, each with several years of experience in financial markets, appointed from the Index Management and Production Group (IMPG) of S&P DJI. IMPG personnel are prohibited from trading any securities or constituents which are, or may be, included in any index that they have oversight or management responsibilities for. Further, all IMPG personnel do not have any commercial responsibilities that might result in the appearance of a conflict of interest.

As an independent index provider, S&P DJI ensures a strict separation between commercial operations and the index or benchmark calculation function. The potential for conflicts naturally arises when an organization is involved in index publication as well as in pricing component securities and/or issuing investment products.

S&P DJI focuses on index publication services and does not engage in any investment banking, equity listing, investment management or trading activities. Therefore, S&P DJI is not prone to the inherent conflicts of interest that confront other index publishers engaged in such side-by-side activities. Similarly, S&P DJI does not take part in the pricing of index components and the issuance of investment products; S&P DJI sources component prices from third parties, such as exchanges, and licenses their indexes to third party product issuers.

As the leading index provider and a founding member of the Index Industry Association, S&P DJI follows the best practices including maintaining independence. This ingredient is important along with the commodity indexing knowledge, unique to S&P DJI, in designing commodity indices that have enabled S&P DJI to offer the DJCI, again, an alternative to the former DJ-UBS.

The DJCI has rid the complexity of world production weight in its weighting scheme. DJ-UBS was a version of the Goldman Sachs Commodity Index when it was originally launched so it used world production, the hallmark of weighting at the time (in 1998), despite lessening its importance by counting liquidity twice as much as the world production in its weight. It then capped commodities, groups of derivative commodities and groups that yielded a well-diversified index. Today, we know if the goal of the index is to be well-diversified, we can simply equal-weight it, then adjust for liquidity – given there is a liquidity tradeoff when reducing energy.

The resulting commodities and weightings for DJCI in 2014 that reflect the simple, equally weighted sectors and liquidity weighted commodities can be seen in the chart below:

Also, please see below the performance comparison of the DJCI, S&P GSCI, and former DJ-UBS.

Based on the characteristics above, the DJCI is well-suited to serving as both an equal-weighted beta and a building block for index modifications, while its subindices are designed to track individual commodities, components and sectors.

A heavy weight battle over economic policy and financial markets is brewing between the Bank for International Settlements (BIS) in one corner and the International Monetary Fund (IMF) in the other. Meanwhile the world’s major central banks may be lining up on one side or the other with the Bank of England (BOE) moving towards the BIS and the European Central Bank (ECB) drifting closer to the IMF. The Bank of Japan (BOJ), having embraced Abenomics, is ahead of the IMF.  The Federal Reserve appears to be seeking a neutral stance, but that could change with the next speech or testimony.

The BIS, the bank for central bankers, argues in its just released annual report that markets are a little too euphoric and giddy; that it’s close to the time when interest rates should be raised.  While the BOE may agree – it has already moved to slow down mortgage lending and rein in a housing boom before it gets out of hand – the BIS is clear that higher interest rates, not limits on mortgages are what’s needed.  Meanwhile, the IMF continues to worry that the expansion might stall and lead to deflation. The deep plunge in first quarter GDP in the US reinforced the IMF’s fears, causing them to cut their forecast of US growth for 2014. The ECB should be, and is, worried about deflation and may be preparing for even lower interest rates and its own version of quantitative easing down the road.

The BIS’s immediate target is to return some real risk to our ever-rising stock markets and remind investors that taking on more and more risk can lead to a bad end.  The BIS is removed from domestic politics in the countries whose central banks it serves; it is in a position to advocate policies like higher interest rates that could push stock prices down. Some of the other banks would find it harder to argue for raising interest rates and discouraging risk taking.

The Federal Reserve, like the other central banks, must be aware of the politics.  For the moment everyone is convinced that the Fed will raise interest rates in the middle of next year.  Until something changes this consensus, the Fed is likely to bide its time, continue trimming back on quantitative easing and watch both inflation and the financial markets.  Whether or not the 2015 consensus is correct, when rates go up, it will be a surprise and stocks will more than likely go down.  We may be safe for the moment.