-- John Kemp is a Reuters market analyst. The views expressed are his own --
By John Kemp
LONDON Equity investors have long been divided over the comparative merits of active management versus passive approaches to investment -- whether portfolio managers can add value beyond the returns on a broad-based equity index in a sustainable way that is not swallowed up by their fees.
"Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds," wrote Professor Burton Malkiel, whose bestselling "Random Walk Down Wall Street" has sold over a million copies in multiple editions since 1973. It remains the most famous exposition of the merits of the index-based approach to investing.
Malkiel's index-based approach is not without critics and an entire active management industry is based on the idea it is possible to add value beyond fees through skilful stockpicking and market timing. But it does capture an important point.
PREMIUMS FOR SHOULDERING RISK ...
Equity investors should expect a positive return from simply holding a portfolio of shares because they capture an "equity risk premium" either in the form of dividends thrown off by companies or appreciation in the stock price. Malkiel doubted whether an active manager could consistently and predictably outperform the index, hence his advice to buy and hold a broad-based index.
Of course, some managers do outperform the index, occasionally for years a time, but it is almost impossible to know which ones will do so in advance. So Malkiel's advice boiled down to the idea of buy and hold a broad index and pocket long-term returns from the equity risk premium.
The same terminology of active management versus passive index-based investing has been appropriated by sellers of commodity products -- with the implication that investors can reap some sort of long-term return just for buying and holding a broad basket of commodity futures and options.
But commodity futures are not like equities at all, and commodity indices have nothing in common with equity indices except the name.
There is no reason why investors should expect a positive real return from buying and holding a commodity index. In particular, they do not capture an equity risk premium and evidence they can capture a premium for shouldering commodity price risk on behalf of producers and consumers is scant.
...VANISH IN COMMODITIES AFTER 2004
Between July 1959 and December 2004 "an investor in our index of collateralised (equal-weighted) commodity futures would have earned an excess return over T-bills of about 5 percent per annum ... (T)his commodity futures risk premium has been equal in size to the historical risk premium of stocks (the equity premium) and has exceeded the risk premium of bonds," wrote Gary Gorton and Geert Rouwenhorst in 2005.
"This evidence of a positive risk premium to a long position in commodity futures is consistent with Keynes' theory of normal backwardation," they argued in a now famous paper on "Facts and Fantasies about Commodity Futures" that kicked off the commodity indexing boom.
But if there was once a futures risk premium that investors could capture by taking on price risk commodity producers were anxious to shed, it seems to have disappeared shortly after the paper was published and investors moved en masse into the new asset class.
Chart 1 shows the various returns (spot, roll, T-bill) available to investors from holding a fully collateralised position in a broad-basket of commodity futures since 1988.
I have used the Goldman Sachs Reduced Energy Index because its reduced weightings for crude are more representative of the indexing sector as a whole and it mitigates the worst excesses of the well-known contango problem in WTI futures. But the conclusions remain true using other indices.
Total returns were mostly positive though rather unspectacular between 1991 and 2004. In addition to gains from appreciating spot prices investors captured positive yield from their collateral and gains from rolling their index positions forward in mostly backwardated markets.
But since 2004, roll yields have become uniformly negative. Roll yields were the component of returns most closely associated with John Maynard Keynes' theory of normal backwardation and the existence of a commodity risk premium. The commodity futures risk premium therefore appears to have evaporated.
Investors' problems have worsened since interest rates were slashed in 2008 because the collateral return from holding safe Treasury bills and bonds has also vanished.
The various generations of commodity indices launched by investment banks and other managers (first generation passive, second generation enhanced, and third generation dynamic) have essentially been an effort to recapture disappearing risk premiums. But the effort may be doomed to failure. There are now so many investors chasing the same risk premium that it may have effectively disappeared for the time being.
WHO IS PAYING WHOM FOR RISK?
Keynes thought commodity producers would be prepared to sell futures contracts for less than their expectation of future spot prices (on average) to transfer price risk to investors. Normal backwardation was essentially an insurance premium. Producers bought price insurance from speculators and investors who sold it.
But the number of index investors anxious to sell this type of price insurance has rocketed over the last decade while there is no evidence the number of potential buyers (producers employing inventory or production hedges) has increased a similar amount.
In fact the number of insurance buyers may have fallen as commodity producers embrace "no hedging" strategies. The commodity futures risk premium seems to have shrunk or disappeared. The market for commodity price insurance appears to have overcapacity.
Increasingly, investors dominate both sides of the market -- with macro and commodity focused hedge funds as well as trend followers and small-scale speculators most often on the long side, and physical commodity traders with inventory on the other.
There are now so many index investors and other holders of long futures positions that are paying a premium to remain long instead of receiving one -- which explains why roll returns have shifted sharply negative in recent years.
BACK TO SQUARE ONE ...
Rather than capturing positive risk premium, commodity index investments have become a straightforward directional bet on prices. Spot price appreciation has provided all the returns to index investors every year since 2004 with the exception of 2006 and (just) 2008 (Chart 2).
But there is no reason to expect commodity prices to continue rising indefinitely at a rate faster than inflation. Unlike their (notional back-tested) predecessors of the 1950s-1990s, commodity index investors should not expect to receive long-term positive returns after inflation.
If there is no longer any commodity futures risk premium to be captured from holding a long position in a broad basket of commodity futures it does not matter much whether investors employ a purely passive index, an enhanced one or a dynamic one. The only sustainable returns come from employing superior skill, knowledge, information and leverage as part of an active management strategy.
This is what some of the new generation of dynamic index strategies aim to do. But there is nothing automatic or index-like about active strategies. They are analogous to actively managed mutual funds rather than broad-based equity indices -- which takes investors right back to the original question of whether active managers can consistently add value beyond their fees.
If investors want long-term returns in the commodity space, they have no choice but to embrace an active strategy -- and most are probably better off buying properly into a discretionary long-only fund or hedge fund.
(Editing by Anthony Barker)
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