Supply of commodities is affected by the gap between the cost of production and the price at which that commodity has been trading
Commodities are different from most other financial assets. Unlike equities and bonds, they do not generate income in themselves – for example in the form of dividends or fixed income yield. In addition, there are costs associated with buying and owning commodities, such as storage costs, which conspire to generate a negative yield on investments in these assets over the medium to long term.
What this means is a “buy and hold”, long-only exposure to commodities is unlikely to generate attractive returns over normal investment time horizons. Much more preferable is to
take a trading approach to investing in the commodities sector, with the ability to establish both long and short positions in the various commodity-related assets.
A second important point is that there is a considerable mismatch in the depth of information and knowledge between insiders and the wider class of investors. Only specialists (and traders fit into this category) have the detailed knowledge of the myriad factors which affect the supply and demand – and hence price – of commodity assets and how these change in time.
Supply is affected by the gap between the cost of production of a particular commodity and the price at which that commodity has been trading, in that producers will only be willing to bear the costs of bringing that commodity to market if it is economically viable to do so.
Furthermore, the timescales involved for different commodity sectors vary greatly, and this must be taken into consideration by producers: an agricultural crop usually occurs annually, while it will take many years to build up the necessary infrastructure to extract oil from a new oil field.
At the highest level, demand drivers include population growth, urbanisation and industrialisation, as well as the emergence of powerful new economies in recent years, predominantly in Asia. Also important is the state of the global economy, in that a buoyant economy is likely to coincide with high consumer spending and demand for goods and a significant investment in infrastructure.
Over and above this high-level knowledge, specialists will have greater insight into the local factors which can affect supply and the ability to satisfy demand for commodities in local markets – for example the costs associated with production, processing, storage, transportation and distribution to consumers.
The commodity asset class is actually very diverse. Traditionally, it is broken down into agriculture, metals (both base and precious) and energy. Each of these can be broken down further: for example, agriculture into coffee, corn, wheat and sugar; energy into various oil-related commodities and natural gas; and base metals into aluminium, copper and nickel.
Newer commodity sectors have emerged in recent years, either because the prices of assets in those sectors are subject to similar drivers to those for the traditional commodities (an example of this would be the transport sector), or because of the heightened awareness of the environmental impact of production and distribution, and the attempts by regulators to minimise this impact through imposing additional costs on firms involved in the commodity supply chain. Examples of the latter include emissions, water, renewable energy and clean technology.
Exposure to these different sectors can be achieved through a range of financial instruments, including equities, exchange-traded futures and options, and physicals. The diversification outlined above re-enforces the point that specialist traders are needed in each of the different sectors, in order to be able to generate attractive profits for investors. The firms that manage funds – more specifically hedge funds – with exposure to commodities thus tend to be specialised “boutiques”, perhaps sitting within larger organisations, employing specialist traders each with many years of experience in their own particular part of the market.
Buying into a small number of such funds may lead to decent, positive performance over the period of the investment. However, such a commodities portfolio would be subject to heightened risks – for example, the risk that any one of the managers may see outsized drawdowns and/or have to close down the fund due to high levels of investor redemptions. Furthermore, this option would not benefit fully from the diversification that can – and should – be the aim of an exposure to commodities.
As a reminder, the benefits of diversification on the returns generated by a portfolio of investments, as opposed to a single investment, include the likely decrease in the volatility of periodic returns and risk of a sizeable draw-down, together with a probable improvement in the risk-adjusted return. Hence, a fund of hedge funds approach should be the preferred option, investing in a portfolio of, say, 15 to 20 (or more) such specialist fund managers.
The management of a portfolio of commodity hedge funds relies on the investment manager having the experience and in-depth resources needed to properly understand the idiosyncratic risks involved, and to be able to construct a dynamic portfolio based on a well-established and structured investment process.
As is the case at the hedge fund level, the number of funds of hedge funds which specialise in commodities is small compared to the wider universe of multi-manager product offerings. Those that exist have demonstrated the ability to deliver attractive risk-adjusted returns with low correlations to equities and bonds –and indeed other hedge fund strategies and long-only commodity indices - resulting from the very different price drivers for the underlying
assets and approaches taken by fund managers in this sector.
Robin Bowie, chairman, Dexion Capital
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