High risk, high return

By Amrith Mukkamala, director of asset allocation for KMEFIC, and wealth management consultant for MEFIC

22 Aug 2011

Investor confidence has been sorely tested by the wild swings across asset markets during the last decade. These swings have broken many previously conceived asset allocation notions and articles of faith regarding modern portfolio theory. The belief in the benefits of adding a commodities allocation to reduce volatility has been one such casualty.

A good example of this is seen in the commodities ETFs/ETNs which witnessed a significant rise in AUM’s over the last ten years. As Barclay’s statistics highlight, global investors increased their allocation to commodities from $15bn in 2001 to $354bn by the end of 2010. That growth in appetite was aided by a belief that the low correlation of the asset class to other asset classes would reduce volatility and provide inflation protection. However, such inverse correlations broke in late 2008 and have persisted until now, thus questioning the very basis for a dedicated allocation to commodities, to what extent and the approach.

Commodities basket

From an investment standpoint, a simple basket of commodities mirroring the widely followed S&P GSCI commodity index would have been one of the worst performing asset classes over the last eight years (2002–2010). This is in spite of spot oil price (almost 65% of S&P GSCI commodity based ETFs) ranking within the top three global asset classes in terms of best risk adjusted return.

This divergence between spot price and investment returns is mainly due to the source of returns. An investor could have mirrored the return pattern of spot crude oil, but only if a physical barrel of oil was purchased. When ETF’s and ETN’s invest in oil futures they suffer an erosion in returns due to roll yield, thereby creating a drag on investment returns as compared to the physical spot price of oil. This is evident during a significant up-move following a prolonged period of weakness in the spot price, such as post-December 2008.

Additionally, the rest of the commodities within a commodities basket do not compensate for this loss in returns due to allocation or low contribution. Gold, which provided the best risk-adjusted return among all asset classes, holds a meagre 3% allocation in a commodities basket. Therefore investors who are looking for a dedicated exposure to commodities need to be very selective within a commodities basket and augment it with alternative ways of gaining a commodity-related exposure.

The importance of right exposure to commodities is emphasised by David Swensen in his seminal work, Pioneering Portfolio Management where he writes: “Unlike commodity indices, which give investors simple price exposure, well chosen and well structured real assets investments provide price exposure plus an intrinsic rate of return.” As a caution against excessive hubris, he was also keen to warn that “pure commodity exposure holds little interest to sensible investors as long-term returns approximately equal inflation rates”.

Another shortfall has been in the addressing the proper application and methodology taken towards implementing commodity exposure which has generally ‘globalised’ investors without appreciation for their important matter of domicile. Case in point: for a global investor the commodity-related equity basket of companies offered by various providers have provided better risk-adjusted return than commodity basket ETFs/ETNs.

GCC-based commodity producers

However, these commodity-related equity baskets such as the Morgan Stanley Equal Weighted Commodity Producers Index and MSCI ACWI Commodity Producers, do not provide exposure to GCC-based commodity producers. It should be noted that GCC-based commodity producers have significant feed stock cost advantages as compared to other global players.

This advantage is directly reflected in the market price of GCC commodity stocks relative to other global commodity producers, especially during times of high crude oil prices. This anomaly is due to an expansion in margin on a relatively stable feed stock costs. GCC commodity producers have generated a high risk and high return profile when compared across all asset classes. Therefore, a global investor has to consider providing a dedicated allocation to GCC commodity producers within his overall commodity allocation.

In a highly typical example, although GCC investors (excluding Saudi Arabia) understand the region’s high dependency on oil revenues, they suffer from limited options through which to gain direct or indirect exposure to commodities. Despite the region’s financial services efforts to provide a means to an indirect route to capture oil commodity returns, the methodology is too circuitous a route for capturing upside driven by energy prices. Recognising that oil revenues are the dominant means of financing GCC budgets and that higher oil revenues translate to both higher government expenditures and increased money supply which are then ultimately channelled through major listed banks, investors are offered only the bank share price as a very weak derivative to approximate the desired commodity.

A superior methodology rather would be to first introduce a measured exposure to global emerging markets (GEM s) in order to add value by diversifying away from the high concentration in financials towards industrials and services. Second, establish a dedicated exposure with a local lens to capture the beta of Saudi Arabian commodity producers within a core commodity portfolio. This core commodity portfolio would be structured to include Saudi Arabian commodity producers and precious metals to augment with GEM s portfolios for better risk-adjusted return. In the more specific context of a Saudi Arabian investor, the local equity market by its nature provides a 31% effective exposure towards energy related commodity companies. This segment of the local market is highly correlated to oil prices, and the concentration of energy- related commodity companies is high. Further, financials, which are the next largest segment, are also indirectly influenced heavily and indirectly by crude oil prices.

Therefore from a diversification point of view, a Saudi Arabian investor should look at moving away from financials and also add a commodities allocation. For this, adding a measured exposure to emerging markets would reduce sectoral concentration and adding precious metals would result in a dedicated commodities allocation. There would be no additional need for an exposure to energy heavy commodity ETF’s. Despite the inherent difficulties, a dedicated and measured commodity allocation is necessary and worthwhile.

However, investing in an ETF/ETN tracking the movement of a basket of commodity prices may not be the best approach to add long-term value as compared to investing in a basket of commodity-related companies. Investing in commodity-related companies with a measured exposure to precious metals would be a relatively better allocation strategy than owning commodity ETF’s. The imperative however is to ensure that the strategy is tailored to fit the regional lens of the investor and the financial extent to which their capital is home biased.