Indexology^® Blog

In my post about globalizing futures, technology and logistics were highlighted as key factors to expand local commodities into a global commodities.  What I failed to mention is that these same keys may unlock potential futures markets growth beyond Earth.  That may seem extraordinary but the potential is real since according to this article on NPR, NASA is planning to grow cress, turnips and basil on the moon.  While it is interesting to think about the spread opportunities that may exist one day between global and extraterrestrial contracts, it may just be that out of this world contracts are so fabulous that they command a fixed premium.

Back to Earth now… The more realistic next big futures market may be in China. I am visiting Shenzhen this week for the 9th Annual China Derivatives Forum, where thousands have gathered to discuss openness, innovation and cooperation in the Chinese derivatives markets.  Many lessons can be learned from the US and Europe, where derivatives markets are more developed, which may help in China’s quest to develop commodity futures.

During my visit, I met with several journalists looking to highlight the importance of China in the commodities markets going forward.  Below is a summary of the most frequented questions:

Q1: How important is the development of China’s futures markets?  The development of China’s futures markets can be highly important for the continued growth of both local and global markets. With growing futures markets, there is greater incentive to produce and store since insurance against price fluctuations is available. This may consequently reduce the volatility of prices for the inputs to goods and help consumers with price certainty. However, there is greater risk-bearing for producers, so to the extent that China is a major consumer and that consumers have choices unavailable to producers, the futures markets may play a lesser role.

Q2: What needs to occur to facilitate the growth of the Chinese futures markets and to get them represented in the major indices? Greater openness, collaboration and continued innovation may be catalysts to help China’s market grow.  Futures contracts that reflect the underlying local physical markets are important to attract commercial hedgers who are in need of protection against price moves. Once there is sufficient liquidity in these contracts, independent indices can be developed only if price data is available for use in the calculation of the index levels.

Q3: For Chinese investors, how do you think they should invest in global commodity indices? Hopefully Chinese investors can enjoy the same benefits as other investors around the world, which have historically been diversification, inflation protection and the potential for equity-like risk and return.  Diversification is now more prevalent since the high inventories have fallen and commodity prices have become more sensitive to supply shocks, which have reduced correlations of individual commodities to each other and commodities to other asset classes to pre-crisis levels,

Q4: What role does China play in the global commodity market, both as a driver and as a trading platform? China is a major consumer of commodities so the demand growth is a key factor in the price formation of commodities globally. As a trading platform, China is developing quickly though their exchanges but products are still in their infancy stage of development.  This may be good news since already there have been about 10 new contracts to market in the past year including some major launches on iron ore, lumber, and crude oil. For areas where there are no great developed futures market like iron ore and lumber, there is an exciting opportunity for diversification.  For commodities that already have developed markets then the question becomes about the similarities and differences between the contracts.  Maybe the popular Brent-WTI spread will get another leg if the Chinese oil contract creates more opportunity.

Q5: How does the impact of demand growth differ between China and India? The demand growth of any consuming country has an impact on commodities.  While much attention surrounds gold demand in India, I think what is really important is the demand growth of oil from India. India is one of the top 10 oil consuming countries in the world and it has the highest projected demand growth rate.  In 2013 demand growth was 46 kb/d or 1.4% and in 2014, the projected rate is demand growth of 3.1% or the equivalent of 104 kb/d added to consumption (according to the Oil Market Report by the IEA).

Q6: What will drive commodities in 2014? The major factors set to influence commodities next year are the quantitative easing, Chinese demand growth and geopolitical tensions. While the Eurozone debt is still on the horizon, the concern seems to have subsided compared with the sentiment a year ago.

It’s widely known that Black Friday, the Friday after Thanksgiving, is the traditional kickoff for the Christmas shopping season. Much like retail shoppers, Wall Street is experiencing a similar event though it does not come with such a defined time period. Early indications of companies attempting to time corporate issuances came in September of this year when Verizon Communication Inc. issued $49 billion corporate bonds just prior to the Sept. 18 FOMC rate decision.  These bonds were very well received by the investor community and, for the bonds that met qualification rules, were eventually added to the S&P U.S. Issued Corporate Bond Index.

It was reported in the press that Verizon executives wanted to sell as many bonds as possible the first time around. By wrapping up the financing early, Verizon essentially eliminated the threat of rising interest rates. The S&P/BGCantor Current 10-Year U.S. Treasury Index’s yield-to-worst had risen 19 basis points from the beginning of the month leading into the September Verizon deal, as market participants worried about the effects of Fed tapering. After the announcement and reassurance of continued stimulus, the index’s yield-to-worst advanced lower, eventually reaching a low of 2.50% on Oct. 23. Since then, yields have started trending back up and discussions have been renewed surrounding the timing of any action in regard to the Fed’s tapering of its stimulus purchases.

As a result of these trends, corporate issuers are once again looking to time their issuance before any significant rate action occurs. The next FOMC meeting is scheduled for Dec. 17-18, and already we’ve seen issuers such as Microsoft Corp. ($3.25 billion) and Johnson & Johnson ($3.5 billion) come to market with issues spanning maturities from three years to 30 years out. The majority of issuance for these two deals meets the S&P U.S. Issued Corporate Bond Index qualification rules except for the $800 million Johnson & Johnson floating rate notes due 11/28/2016, which, as stated in the index methodology, are excluded for not being fixed rate. The demand for yield is strong and the recent increase in rates has whet the appetite of investors while still remaining attractive to corporate CFO’s. We could see further corporate issuance this year as firms attempt to secure financing before any possible increase in rates may occur.

Yesterday’s Wall Street Journal offered a profile of fixed income investors who aim to “break [the] chains” by which they are supposedly confined by index benchmarks.

As the bond market falters, investors are seeking shelter in funds that aren’t tied to indexes.  These bonds funds are known as “unconstrained,” “go-anywhere,” “absolute return” or “flexible” funds, and they are gaining in popularity on both sides of the Atlantic…

This echoes a theme we also hear in the equity markets — that managers need to be “more aggressive” (typically by holding fewer stocks) in order to improve their performance.

Improving performance is not quite as easy as the article implies.  Moreover, investors, both institutional and individual, compare managers to indices for a very good reason.  The reason is that absent some objective standard, the fund owner has no way to judge whether the asset manager’s performance was good, bad, or indifferent.  Admittedly, “some objective standard” covers a lot of ground — not losing money in a quarter, or earning at least 10% a year, are both objective standards.  But indices are uniquely well-suited to be the standard by which asset owners evaluate asset managers.

Most broad market indices — whether they measure equities or bonds — are capitalization-weighted.  Such an index will accurately reflect changes in the total market value of the asset class in question.   One of the most important characteristics of any asset class is that there is no net supply of alpha.  In other words, one manager can be above average only if another manager is below average.  The aggregate amount by which the above-average managers outperform the asset class must equal the aggregate amount by which the below-average managers underperform.

By comparing manager performance to that of a well-diversified, cap-weighted index, an asset owner realizes two benefits:

• He assures himself that his bogey is reasonable in view of the opportunity set available to his managers.  In 2011, with the S&P 500 up 2%, it would have been foolish to expect a U.S. equity manager to meet an absolute 10% bogey.  This year, with the 500 up 29% through November 30, it would be equally foolish to be satisfied with 10%.
• Since there is no net supply of alpha, roughly half of all managers will outperform their asset class and roughly half will underperform.  As a convenient shorthand, a manager who beats a well-diversified cap-weighted index is likely to be an above-average manager.

There are as many putative paths to outperformance as there are active managers (or active managers’ marketing departments, which is more or less the same thing).  None of them will be impeded by asset owners’ use of well-chosen indices to evaluate manager performance.

Globally, over 6 billion U.S. dollars are invested in India Equity ETFs, although less than 200 million via products listed in India.  It’s reasonable to suppose that Indian demand is reflected in the local figures, transferring wealth across Indian borders is both difficult and expensive.  Thus, on the face of it, these figures suggest general indifference to passive investing within the Indian financial community, despite substantial passive interest in India from outside its borders.

The debate between proponents of passive and active investing has been raging for close to a century.  And when it comes to India, the evidence favours the passive investor, much as it does in more-developed markets.  But – in India as much as elsewhere – very few investors are limited to a single asset class.  From the perspective of a multi-asset portfolio, the real picture is much more complicated, and potentially more rewarding.

When looking across asset classes, there is no universally-agreed definition of what ‘the market’ actually is.  In the absence of a widely-accepted bogey, in practice investors frequently build their own: a benchmark comprising a custom blend of markets across a variety of asset types and geographies, representing their overall allocations.  And here’s where it gets interesting.  The impact of changing asset allocation is usually much more significant than changing an individual component benchmark, or changing a component between active or passive allocations.   An investor, manager, advisor or consultant adds the most value when he gets his asset allocation right.  And given the time and effort spent on choosing individual managers, arguably the most efficient way for an investor to spend his time is to focus on actively managing an asset allocation among passively managed components.  In fact, a key driver of ETF growth across the world – ranging from US financial advisors and institutions, European macro-funds and through Asian retail investors – is through such active management via passive asset allocation.  Sometimes old foes can find a new partnership.

These are important considerations for investors in India and elsewhere.  To learn more, please join us for a live 60-minute webinar on December 12, 2013 to hear from practitioners at Kotak Mutual Funds and S&P Dow Jones Indices.  We’ll discuss the trends, opportunities and challenges in investing actively through passive building blocks.

Robert Shiller, Yale economist and author of Irrational Exuberance, who warned of 2000 Tech bust and the housing bubble is warning that equities may be a bubble. Year to date, the S&P 500 is up 26.7% and the Dow Industrials are up 22.4%, both before dividend reinvestment.