Morningstar Advisor - Summer 2008 - (Page 26)

Gray Matters Commodity prices and the level of investment in commodities strategies have risen significantly in the past few years. With more investors focusing on commodities, more money is expected to pour into commodity indexes through exchange-traded products, mutual funds, and futures. Commodity-index-linked investment vehicles now command approximately $185 billion, and this trend seems unlikely to abate. There is reason to question, however, how well investors are being served by these traditional long-only commodity indexes as either benchmarks or proxies for investment products. Traditional approaches to representing pure beta exposures work well for stocks and bonds but not so well for the commodities asset class. While we do not offer an approach to taking pure beta exposures in this study, we assert that new passive strategies that use a momentum-based long/short approach rather than the long-only approach of the most common commodity indexes are better benchmarks for active strategies. No Such Thing as Commodity Beta es in the commodities indexes. The S&P GSCI, for example, has about double the weighting to the energy sector as have the Dow Jones-AIG and the Reuters Jefferies, and only one third of the weighting to agriculture. Sources of Excess Return commodity producers (wheat farmers, for example) and consumers (cereal manufacturers). Therefore, they both have incentives to hedge against the risk of future price fluctuations. The futures markets provide one of the most common and effective ways of hedging price risk. When there are more producers who need to hedge than consumers who do, speculators (including investors in commodity futures strategies) enter the market and provide insurance against falling spot prices by taking the long side. Speculators receive a premium for this insurance in the form of a futures price that is less than the expected future spot price. Hence, they expect the futures price to rise as it approaches the actual future spot price over the life of the contract. Conversely, net hedging pressure can be greater on the long side. That is, when there are more consumer hedgers than producer hedgers, speculators provide insurance against rising futures prices by taking the short side, leading to a futures price that is higher than the expected future spot prices. Hence, they expect the futures price to trend downward as it approaches the spot price over the life of the contract. The Storage Market Professional commodity-trading advisors often take both long and short positions in commodity futures. Why? Because they know that long-only strategies provide inadequate investment exposure to commodities. A futures strategy generates excess return from two sources: changes in futures prices and the roll yield. The roll yield, which can be positive or negative, results from replacing an expiring contract with one farther away from expiration. This allows the trader to avoid the physical delivery of the commodity yet maintain positions in the futures markets. To understand these two sources of return, investors need to analyze three interrelated markets for each commodity—the spot market, the futures market, and the storage market—and their effects on each other. The Spot Market For many asset classes, it is very easy to take a pure beta exposure—multiple asset class proxies are available, many of which are reasonable substitutes for each other. The Russell 3000, S&P 500, and Wilshire 5000, for example, are representative of the broad stock market and have similar risk and return characteristics; the Citigroup Broad Investment-Grade, Lehman Brothers Aggregate, and Merrill Lynch U.S. Domestic bond indexes mirror the wider fixedincome market and perform alike. Yet for commodities, fewer choices and more disparity exist among the index options. The risk and return characteristics of three commonly used commodity indexes—the S&P GSCI Commodity Index, Dow Jones AIG Commodity Index, and Reuters Jefferies CRB—vary greatly. Dramatic differences in constituents and weighting schemes and rebalancing rules are likely the cause for the performance differenc- The spot market is the cash market for the commodity itself. Commodity prices fluctuate based on the supply and demand of any commodity. If there is excess supply, then inventories build up until there is downward pressure on prices and producers reduce supplies in response to that price signal. In case of excess demand, inventories will be drawn down until the shortage causes prices to rise and equilibrium is restored. It can take significant time, however, for inventories to be regulated through price changes due to production and storage situations, leading to trends in commodity spot prices. These trends are reflected in futures prices. The Futures Market Producers of storable commodities use inventories to fill gaps between production and sales. Similarly, consumers use inventories to fill gaps between consumption and purchases. This creates a market for storage. Storage is costly, however. Besides the direct cost of physical storage, there is also an opportunity cost because the money tied up in the commodity could be earning interest. On the margin then, an extra unit is only worth storing if the benefits of storage are at least equal the costs (including the opportunity to earn interest). If this benefit is high enough, it makes more sense to store the commodity for future use or sale than using or selling it now. It also means that the futures price will be lower than the spot price, causing time to expiration and the futures price to be inversely related. The further out the futures contract, the lower Wild fluctuations in spot prices can lead to the risk of operating losses for both commercial 26 Morningstar Advisor Summer 2008

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Summer 2008

Morningstar Advisor - Summer 2008 Contents Letter from the Editor Contributors Inbox College Planning: Solutions and Concerns ETFs: The Next Chapter Engineering Financial Advice Investment Briefs Flexible vs. Style-Pure Managers: The Evidence Forging a New Commodity Index Work Your Way Through College Planning Sizing Up the Options Best and Worst 529 College-Savings Plans A 529 Travel Guide 10 Tax-Smart Tips for College-Savings Planning Global Dialogue How Sequoia Cranks Out Good Returns Year After Year The Many Layers of David Winters Living on the Edge Stocks to Buy Once a Decade With Munis Feeling the Pain, Some Opportunities Arise Health Care Provides Shelter from Economic Storm Help Your Clients Get More Out of Their Bond Portfolios Mutual Fund Analyst Picks 50 Most Popular Equity ETFs Undervalued Stocks Most Popular Variable Annuities New at Morningstar New on MorningstarAdvisor.com Closer to Fine

Morningstar Advisor - Summer 2008

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