If you were to ask a few commodity experts what is going on with precious metals (like an attendee did at our 8th annual commodities conference), the answer is long-winded since the story is different for each commodity. A few years back, the answer was far more simple where it depended on the RORO environment that overpowered supply and demand models of individual commodities and spiked correlations. The quantitative easing caused all the commodities to move together, and the excess inventories with destroyed demand caused them to fall (except gold – the safe haven that acts like currency.)
Fast forward to today and that has all changed. As inventories have depleted, supply shocks have become prevalent so correlations dropped. Sounds like an active manager’s dream, right? Maybe not. While this environment hovers near equilibrium causing swings across the zero line, there are abundant opportunities, winners and losers. So what’s the problem? Picking the winners. At our conference, we asked about the best calls for the year and got a mixed bag of answers. For single commodity plays, we heard long sugar, copper, nickel and short natural gas. For spreads, we took a poll of the registrants to uncover their beliefs about the best trade that resulted in about 40% corn-wheat, followed by about 33% WTI-Brent and 27% copper-aluminum. There are no clear answers and at this time when commodities seem to be mean reverting, the risk of being wrong and getting whipsawed is high. That is why diversification is important.
The points of majority agreement at the conference according to the polls, were that 53% felt investors will move money from active to passive, and 77% felt over the next three years that money will flow into commodities. Why? Diversification. Current correlations and roll yields indicate commodities are still an effective asset class in a portfolio, but not just via plain beta.
The return opportunity likely sits with assuming identified risks; therefore, risk premium strategies applied in a systematic way to capture variable contract expirations, less typical roll windows and different weighting schemes may be how to get the value from beta. In other words, using a diversified set of factors may be the way to capture commodity risk premiums.
The newly launched Dow Jones – RAFI Commodity Index (DJ-RAFI CI) is designed to be a fundamental factor-weighted, broad-market commodity index with a modified roll. Notice although the DJ-RAFI CI has high correlations (3 yr) with the DJCI and S&P GSCI of 0.97 and 0.90, the current returns are better. This is the reflection of the power of factor investing in this environment.
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