Raw materials are on fire. But for private investors, accessing a notoriously volatile and unpredictable asset class through a simple fund structure is easier said than done. The most popular route for private investors so far has been commodity equity funds, with BlackRock’s resources team dominating most of the lists. Their World Mining Trust has gained 53% in the past 12 months.
But commodity stocks don’t necessarily move in line with the underlying commodity market. The stock price, for example, Glencore or BHP moves for many different reasons, including underlying cash flows and manager decisions.
Investors looking for more direct exposure to commodities tend to focus on funds that track a major commodity index, such as those offered by Bloomberg or S&P Dow Jones. The main vehicles here are either exchange-traded funds (ETF) or exchange-traded products (ETP). The most popular version of ETFs tend to be broad commodity index trackers offered by WisdomTree or iShares. These large trackers use a composite index comprising sub-sectors ranging from oil to agricultural products, such as pork or wheat.
A technical problem
Underlying these large indices are futures contracts: promises to buy a specified commodity at some point in the future (one to 12 months is a normal range). However, the funds do not intend to take physical ownership of the commodities. The idea is to “renew” the so-called first month futures contracts each month. The fund manager sells futures contracts as expiration approaches, then buys the next month’s contract.
This is normal practice, but it can lead to a technical problem that reduces returns: negative roll yield. Just as bonds have a yield curve, with interest rates over different durations sloping up or down, there is a commodity-futures curve: the futures price often deviates from the actual and physical spot price. If the futures curve is rising (in other words, futures are more expensive than the spot price), the market is in “contango”; if it is falling, it is in “offset”.
If the market is in contango, then, as is usually the case, next month’s contract is more expensive than the one that just ended and the fund manager basically pays a fee for buying a new contract. . The cumulative impact of this negative roll yield can be substantial: most classic one-month commodity rollover strategies tend to underperform spot prices over extended periods of time.
This forced ETF issuers to experiment with complicated adjustments to the futures-based strategy. WisdomTree, for example, offers a successful lineup of enhanced funds that track one of the broadest commodity indices – the S&P GSCI – using a dynamic rollover strategy. The aim is to “minimize the potentially negative effect of rolling the futures contract by determining the most efficient rolling on the future curve for each commodity”. iShares has a similar fund called Bloomberg Roll Select Commodity Swap, while XTrackers has something called Commodity Optimum Yield Swap.
These widely followed commodity indices pose other problems. Some end up becoming dominated by energy prices, while others tend to exclude agricultural sub-indices because they can be too volatile. ETFs have responded with ideas such as assigning equal weighting to various sub-sectors (Lyxor, for example, has a Bloomberg Equal-Weight Commodity ex-Agriculture).
Currency fluctuations are also a risk, with major commodities markets trading in dollars even though UK investors are concerned about sterling returns. WisdomTree, among others, offers a full range of commodity trackers hedged against currency risk.
The weather is another potential risk. In natural gas, oil and agriculture markets, prices are affected by the season, while commodity markets can be prone to rises and falls as investors pursue broad themes.
Add all these complexities and eccentricities together and it is understandable why many institutional investors tend to avoid index trackers and instead opt for specialized commodity funds with active managers. They’re experts at playing all of these trends – roll performance, seasonality, momentum – but they tend to charge for the privilege. The funds are also almost all inaccessible to private investors.
A cheaper option
Interestingly, however, Legal and General’s ETF branch – LGIM ETFs – took many of these ideas and incorporated them into a new listed ETF: the L&G Enhanced Commodities UCITS ETF (LSE: ENCG). The fees are much more favorable to private investors at 0.3% per annum.
The ETF takes various observed market processes and then develops a systematic series of strategies to improve returns. So when it comes to the rollover problem, the underlying index – from Barclays – uses a range of futures optimization techniques. This can mean using a combination of one-month, three-month, and one-year contracts.
The strategy is also interested in the curve of the futures contracts then “allocates along the curves in order to optimize the characteristics of the roll yield”. Simply put, instead of paying an active manager to watch the curve, the quantitative system automatically allocates money where the opportunity might be greatest.
Added to this is what is known as an “alpha momentum” strategy for the agriculture and livestock sectors, which dynamically aims “to allocate to points on the curve that have historically outperformed”. The fund also aims to replicate market returns in the precious metals sector.
Add it all up and with luck you should get an optimized return in the commodity markets at a relatively low cost. ETF issuers performed a back test on the strategy, which suggests that the underlying index (the Barclays Backwardation Tilt Multi-Strategy Capped Total Return index) has outperformed every year since 2009. It is no longer missing from the funds as an exchange hedge for the pound sterling. investors.