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Can Investors Achieve Commodity Exposure Via Equities?

By Wesley R. Gray, Ph.D. This past year we examined the possibility of replicating commodity exposure via equities. The project was spurred by an insightful research report from MSCI , which showed some impressive results. Other research outfits have proposed similar concepts . The figure below, taken from the MSCI report, highlights how well the MSCI Select Commodity Producers Index replicates various commodity indices over 2010-2012: (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. We replicate these results and come to similar conclusions: Correlations for commodities and commodity-related-equities are > .8 from 2010-2012. However … and this is a big however… When we look at a longer out-of-sample period, from 1991 to 2014, correlations are much lower (the best versions of our algorithms can get the correlation in the .6-.7 range after intense data-mining). The executive summary below is from a 125-page internal report we did on commodity via equity replication. The correlation figures represent the full-sample correlations between the underlying commodities and some of our top replication techniques. Clearly, the evidence below suggests that we should be skeptical of claims that commodity exposures can be effectively replicated via commodity-related equities. Especially, when the sample period analyzed is short. (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Understanding Commodity Replication via Equities Accessing commodity exposures can be complicated. Consider oil exposure: Buy oil futures? The oil ETF? Oil stocks? Each of these option has pros and cons. Futures Futures appear straight forward, and require less margin than equities; however, these contracts trade in large notional amounts (eliminating the option for retail investors), incur transaction costs (potential roll costs and other transaction costs), and trading futures should not be viewed as a buy-and-hold investment (e.g., see research here and here ). Many investors view commodity futures like stocks, where an investor simply buys and holds over the long term and grinds out the equity risk premium. But this is not the right frame of thinking. Commodity futures aren’t equities. Futures are a traded asset class, and being active – not passive – is the only way to capture the potential risk premiums offered by commodities (e.g., term structure). ETFs that own futures One can buy an oil ETF that owns oil futures, which is simple and requires less capital, but there are management fees, and these funds still have embedded future trading costs. Stock replication One could also explore investing in stocks that are in the oil business. This approach has some huge potential benefits: tax-efficiency (i.e., deferral), simplicity, no roll risks, dividend payments, etc. However, the biggest risk is that oil stocks may not necessarily capture the exposure of oil future prices. For example, some oil producers may hedge production, thus limiting their business exposure to underlying oil price fluctuations, and thus, their correlation to the underlying commodity. In order to deal with this risk, one needs to engineer a specific portfolio and actively manage the exposures. How to Replicate Commodity Futures via Equity Portfolios In this piece, we look at different algorithms that form portfolios meant to capture commodity risk exposure via equities. To facilitate understanding, we focus on an analysis of the energy sector. In order to replicate commodity returns with stocks, we look at 3 approaches (one can mix and match or add additional techniques, but these are the big muscle movements): Identify commodity-related sectors and the associated stocks (e.g., oil sectors stocks should follow oil more than information technology stocks would). Identify % revenue generated by specific sectors (e.g., an oil stock that generates 95% of its revenue from the oil sector is better than one with 51%). Identify past correlations between stocks and commodities (e.g., an oil stock with a 90% historical correlation is better than one with a 50% correlation). In the end, we perform a variety of data-mining techniques that mix and match various elements to try and data-fit the portfolios that have the highest correlation out-of-sample. Here is an example combination approach that seems to be most effective in our research: Identify companies in a specific SIC sector (e.g., primary SIC code is energy). Confirm that the firms identified have 50%+ of their revenue from energy For firms identified in steps 1 and 2, calculate rolling past 12-month correlations with energy returns. Purchase the top 10% highest correlated firms (can equal-weight or value-weight the portfolio) Monthly re-balance. Some Example Results SP500 = S&P 500 Total Return Index future_energy_ew = equal-weighted across 6 energy futures (natural gas, crude oil, Brent crude, gasoline, heating oil, and gas oil) equity_energy_ew_12m daily corr = equal-weighted, top 10% 12-month rolling correlation using daily returns, re-balance at the end of month equity_energy_vw_12m daily corr = value-weighted, top 10% 12-month rolling correlation using daily returns, re-balance at the end of the month Results are gross of fees. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Summary Performance 1992/05 to 2014/12 (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. The correlation results are not promising – average correlation is 65-67% – a far cry from the 90%+ results we’d like to see if we wanted to replicate commodity future returns with equity. Invested Growth 1992/05 to 2014/12 (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Energy-related stocks don’t track energy sector futures that well over time. Looking inside the black box: Sample stock names as of 2014/12/31, market cap in millions (click to enlarge) The results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Conclusion Based on the analysis above, replicating commodity futures via equity is mediocre, at best. In contrast to MSCI, we’re not convinced . Determining if commodity exposure is a benefit to a portfolio is a complex issue, but given that one believes in the benefit of exposing a portfolio to the commodity sector, trying to access these exposures via equity replication probably isn’t going to work that well… at least not as well as previously contemplated. Original Post

Patience And Liquidity

The continued drop in commodity prices raised fears in the financial markets that global growth was slowing to a crawl. The result? Bond prices rose while stock prices fell. It is clear that there is overproduction relative to demand in most commodities. This is highlighted by energy. Prices continued to decline last week. Each commodity has its own dynamic but in virtually all cases production is increasing year over year at a rate surpassing demand growth. The key takeaway is demand and production are increasing. Major producers are finally cutting back production to levels equal to or beneath demand growth so that inventory levels stabilize or actually decline, which is a prerequisite for pricing power moving forward. It will take time and patience. Unfortunately there is a lot of speculation in the commodity markets and continued weakness in prices initially led to margin calls and now outright liquidation. Markets typically move too far each way. Fear of a further collapse in the commodity markets has spilled over into other financial markets creating opportunities for investors who have been patient and maintained their liquidity. I have stated that lack of or no growth was my biggest fear. But let’s put all of this in perspective: the U.S. economy is improving led by the consumer; China reported 7.0% growth last quarter and its stock market has rebounded of late; Greece is settled, at least for now, lifting a big cloud over Europe which will lead to renewed growth; Japan is doing fine led by exports; India is continuing to accelerate and will grow over 7% this year however many third world countries are suffering. The world is growing over 3.0% this year which may be less than in the past. Global growth should improve in 2016, too. Don’t forget that the drop in oil prices recently from $60 dollars per barrel to around $48 per barrel will boost consumer disposable income around the world and lower inflationary expectations boosting bond prices from what they otherwise would be at this point in the economic cycle. Beside the consumer, the drop in energy and other commodity prices are good for corporate margins in the aggregate but of course not for the commodity producers themselves. By the way, we added to our energy shorts after it appeared that a deal would be reached with Iran, which we discussed in previous pieces. It was an easy call. Over 70% of companies reporting so far have exceeded their forecasts for the second quarter and maintained or raised numbers for the year. Not too bad. Rather than reviewing events by region as we have done in the past, I’d like to review my core beliefs and see if there are any changes that may influence my investment policy: Monetary policy remains easy virtually everywhere and the supply of funds is exceeding the demand for funds, which is favorable for financial assets. It is clear that the Fed is on hold until year-end or early 2016 at the earliest removing an immediate concern in the marketplace. The dollar has remained the currency of choice, which may impede U.S. economic growth but also lowers inflationary expectations. Positive capital flows from abroad continue to reduce our interest rates from what otherwise they would be. The yield curve will steepen but the degree may be less than initially thought due to the sharp drop in commodities, weakness overseas and strength in the dollar reducing inflationary expectations further. A new conservatism permeates governments, corporations and individuals is clearly true. Just look at new Fed rules for the banks and at corporate cash flow reported for the second quarter so far. Hillary Clinton’s tax proposals are not good for the economy, capital formation and investment but may improve the Republican’s chances in the next Presidential election. Profits will surprise on the upside clearly occurred with second quarter results reported so far. Financial leverage and capital ratios will continue to improve. Clearly this is the case as most corporations are capping capital spending at depreciation therefore generating a lot of free cash. Banks continue to raise capital ratios and reduce leverage and risk. M & A activity will remain strong. Just look in the newspapers every day to see deals of all sizes. Both the acquirer and the acquired company’s stocks rise, as most deals are anti-dilutive day one. Commodity prices continued to decline as producers remained slow to cut back production at levels to or beneath demand growth so inventories continued to rise and prices fell. But lower commodity prices are good for inflation, interest rates and profit margins. Not for commodity companies though. Corporate managements are acting as their own activists recognizing that change is a necessity to survive and thrive in a globally competitive landscape. A Greek default was contained although I doubt that Greece can live up to the terms of its new deal with the ECB. The can was kicked down the road. I still doubt that the Fed can begin raising rates until 2016 and overall policy will remain easy. Future rate hikes will be small and spread out unless there are major changes in the outlook for the U.S and global economies. The economic cycle will be extended with lower highs and higher lows. Still valid. There are few, if any, excesses. Speculation exists today in real estate, private equity and art. Still valid. My beliefs remain for the most part intact. I continue to be pleasantly surprised by how managements are adapting to this global competitive environment. Management is everything to me. There is a reason why Alcoa, Dow Chemical, GE, Honeywell, Nucor, JP Morgan Chase, Wells Fargo are best in class. Then take a look at Facebook, Google, Apple, Starbucks, Visa to name some more. I am long 25 of the best managements in the world who have winning long-term strategies regardless of the economic environment. And that is the key to be a successful investor. Be patient and maintain ample liquidity at all times to take advantage of market moves like last week. While change is in the air it does not happen overnight. Follow your beliefs and challenge them at all times. Invest in stocks, not markets. Invest accordingly! Share this article with a colleague