Morningstar Advisor - Summer 2008 - 28

Gray Matters How They Stack Up: The risk-return profile of Morningstar’s commodity indexes rank favorably with other benchmarks. Note the Morningstar Long/ Short Index’s high return and moderate risk compared with the S&P GSCI and the Dow Jones-AIG. The index also does a good job of limiting downside risk. Its maximum drawdown in the 1991–2007 period was less than one third that of the DJ AIG Index and less than one fourth of that of the S&P GSCI Index. Risk Return Profile 01/91–03/08 Index/ Sector Compound Annual Return % Annualized Std Dev% Downside Protection Profile 01/91–03/08 Index/ Sector Maximum Drawdown % Annualized Sharpe Ratio% Morningstar Long/Flat Morningstar Long-Only Morningstar Long/Short DJ AIG S&P GSCI S&P 500 LB Aggregrate Bond U.S. 30-day T-Bill Source: Morningstar 10.80 11.17 11.32 8.37 7.28 10.59 7.09 3.81 9.57 13.50 10.08 12.57 18.70 13.50 3.70 0.43 Morningstar Long/Flat Morningstar Long-Only Morningstar Long/Short DJ AIG S&P GSCI S&P 500 LB Aggregrate Bond U.S. 30-day T-Bill –8.83 –35.28 –11.39 –36.20 –48.26 –44.73 –5.15 0.00 0.73 0.59 0.74 0.41 0.29 0.51 0.79 0.00 available from shorting futures when there is downward price pressure or a positively sloped futures price curve. Long-only indexes generate negative roll yields when markets are in contango and thus can have negative returns when commodity prices are rising. Furthermore, because many actively managed commodities trading advisors invest in long and short futures based on momentum trading rules, the longonly indexes are not appropriate benchmarks, rendering traditional approaches to representing beta exposure unsuitable. By using a momentum-based approach that takes into account both price change and the slope of the futures price curve, Morningstar’s new indexes aim to maximize both sources of excess return—price change and roll yield. In addition, the indexes are logically consistent with the underlying economics of commodities futures markets, and back-tested results show an attractive risk profile, low downside risk, and low correlations to both traditional asset classes and long-only commodity indexes. As passive investment alternatives, these rules-based indexes could offer easier access to actively managed commodities trading strategies. K Paul Kaplan, Ph.D., CFA, is Morningstar’s vice president of quantitative research and a frequent contributor to the magazine. He last appeared in the Spring 2008 issue with an article titled “Let’s Not All Become Fundamental Indexers Just Yet.” futures strategy. Such passive strategies are also likely to prove a better benchmark for the active strategies of professional futures investors. To make this idea operational, Morningstar created a new family of commodity indexes that includes combinations of long commodity futures, short commodity futures, and cash. The primary index, called the Morningstar Long/Short Commodity Index, holds commodity futures both long and short based on momentum signals. The other indexes are derived from the long/short index. The Morningstar Long/Flat Index holds cash in place of the short positions in the primary index. The Morningstar Short/Flat Index holds cash in place of the long positions. The family also has long-only and short-only versions. We created a set of single-commodity indexes to serve as constituents for the long/short index and the related composite indexes by calculating a “linked” price series that incorporates both price changes and roll yield. The weight of each individual commodity index in each of the composite indexes is the product of two factors: magnitude and the direction of the momentum signal. We set the magnitude based on a 12-month moving average of the dollar-weighted open interest of the commodity. We then cap the top magnitude at 10% and redistribute any overage to the magnitudes for the remaining commodities. The direction depends in part on the type of composite index and in part on the type of commodity in the long/short index. In the long/short index, each month, if the linked price exceeds its 12-month daily moving average, the index takes a long position in the subsequent month. Conversely, if the linked price is below its 12-month moving average, the index takes the short side. The Long and Short of It Long-only strategies that dominate the commodity index market do not best serve investors as investment vehicles or as benchmarks. Because futures price changes and roll yields are the sources of excess return, long-only indexes have no way to capture the returns 28 Morningstar Advisor Summer 2008

Morningstar Advisor - Summer 2008

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