1. June 2016
1
olatility in the financial markets triggered
by mismatched expectations surrounding
central bank policy, the likelihood of a
hard landing for China, US growth, and
Brexit, highlights both uncertainty and opportunity.
There exist a myriad of interesting political and
economic questions to ponder, but from an investor
perspective there remains a more practical and
immediate question - how to position portfolios for
what seems to be a very nervous and choppy market.
Even Goldman Sachs has turned gloomy “owing to
heightened drawdown risk and growth scarcity,” and
in a recent research note cautioned investors “both
equity and bonds could sell off.”
Though most investor portfolios will remain heavily
weighted towards traditional long-only equity and
fixed income, there exist a number of investment
strategies that can profit without the tailwind of
rising asset prices, benefiting instead from changing
volatility regimes, arbitrage events and, perhaps, an
information advantage.
One method to mute portfolio volatility and improve
overall return may be an allocation to managed
futures. When some investors are guided towards
Commodity Trading Advisors (CTAs) alarm bells go off
as they envision large exposures to energy, metals
or currency, to which they already have abundant
exposure (or at least sensitivity) in their portfolios,
or of gold, which is clearly hit or miss depending
on perspective. Investable commodities for CTAs,
however, can include anything from cocoa to corn
and lumber to rubber.
These commodities managers may in fact benefit
from a distinct advantage over their equity and
fixed income peers – that is they seem to have a
credible information advantage. Whilst a difficult
pill to swallow is that one investor has a competitive
advantage in understanding Apple or Google over
another, it does however sound plausible that a
seasoned futures trader can better interpret the
shape of a curve, opportunities associated with
contango and potential pitfalls of negative roll yield
relative to many other investors.
A contemplated investment in wheat, for example,
aptly underscores the necessity of understanding the
nuances of agricultural commodities before treading
into the market. Jay Cassidy, CIO of Perennial Capital
and veteran commodities trader, points out that
Variable Storage Rates (VSRs) “were designed to
expand the cost-of-carry for wheat during heavily
supplied, weak basis, environments in an attempt
to better enhance the cash to futures convergence.”
An increase of these VSRs makes a big impact on the
investment decision, and according to Cassidy, “an
initial increase can ramp on the annual cost-of-carry
by over 30% for a passive long-only holder of wheat.”
These buzz words - cost-of-carry, contango and
roll-yield - often materialise in the mouths of the
investment community at large but are perhaps
difficult for some to comprehensively dimension if
taken to task. In any event, the commodities space is
clearly less crowded than that of stocks and bonds,
though of course often more thinly traded too.
Investors have long grappled with the decision
whether to include managed futures in their
portfolios. In a cynical and sarcastic myth-busting
assault, Forbes published Frank Armstrong’s gospel
of the ‘Nine Reasons to Just Say No to Managed
Futures’. The gist of his argument is that managed
futures have no expected return, uncertain
correlation benefits, unproven history as a portfolio
investment, opacity, limited access and extremely
high cost. Although analysis has shown CTAs tend to
be uncorrelated to equity and fixed income, they can
experience large periods of drawdown that in the
short-term may feel like a costly premium to pay for
portfolio diversification.
Another reason why investors may be put off by CTAs
is that they often have lackluster returns relative to
stocks and bonds during strong bull markets. This
has been particularly acute over the recent long-
running rally. And in the eyes of many investors,
whether or not CTAs provide insulation against
inflation (some do, some do not) matters little, as
these pressures are perceived by many to be a long
way off.
Those that do opt to make an allocation to
commodities face a much debated and fundamental
decision whether to invest passively or through
an active manager. There are benefits to each
approach, but an allocation to an active manager
over a passive structure seems to have more pros
than cons. Certainly an ETF will have lower cost
and probably preferred liquidity terms, but a highly
skilled manager should more than compensate
with intimate knowledge of the commodities
markets and greater flexibility of investment in
a market where knowledge and flexibility truly
matter.
With commodities, where value can be greatly
impacted by a multitude of factors - including
profoundly difficult ones to forecast like weather -
the ability to dynamically change trading strategy
and direction is crucial, as it offers abundant profit
opportunities for seasoned traders. A current
tangible example exists in raw sugar where “a
four-year supply surplus bear market (from 2011)
has ultimately led to a supply malaise,” says Oliver
Kinsey, Portfolio Manager at Ballymena Capital.
The world’s two largest producers – Brazil and India
– have been forced to operate under the cost of
production, and Kinsey estimates that the “ensuing
consolidation and bankruptcy has caused Brazil
Center-South sugarcane capacity to be cut from
its peak of 331 mill producers in 2010 to 284 mills
today.”
With robust annual demand growth, the supply
shortfall has been further exacerbated by the
historic El Nino weather event in 2015 that
clipped as much as a tenth of the potential
crop of both. A weak monsoon in 2015 has
further reduced plantings in India, which could
turn the world’s second largest producer into
a structural importer over 2016-17. Current
conditions present unique opportunities
for the right trades but also call for careful
exposure management and nimble reallocation
among strategies as conditions change.
Reap What You Sow
The role of commodities in a drought investment climate
BEN FUNK
V
Fig.1 CTAs’ performance during the 20 worst months for the S&P500 over the past decade
Source: Bloomberg
-15%
-10%
-5%
0%
5%
Oct-08
Feb-09
Sep-08
Jun-08
Jun-09
May-10
Nov-08
Sep-11
Aug-15
May-12
Jan-08
Aug-11
Jun-10
Jan-16
Aug-10
Nov-07
Jan-10
Jan-14
Feb-06
Jul-07
CTAs S&P 500

2. June 2016
2
ETFs and index funds tend to be long only and are
often required to hold a certain portion of their
assets in each futures market regardless of the
fundamental drivers of the spot commodity price.
They typically are structured to hold long positions
in the near-dated contract, regardless of the shape
of the curve and the size of the positive or negative
roll yield. Timing of the roll of a contract can have
a very significant impact on performance, and
passive structures tend to be very mechanistic.
Active managers, on the other hand, are at least
theoretically advantaged from greater degrees of
freedom in their selection of contracts. They have
the mandate to make short (bearish), market-
neutral or long (bullish) investments and will
attempt to strategically roll their positions at a date
other than that of the index rolls, thereby greatly
reducing the market impact of their maneuvers.
Long-term allocation to CTAs can improve the
risk-adjusted performance of typical investment
portfolios. This is partially due to low (or even
negative) correlation between managed futures
and traditional long only equity and fixed income
investments that dominate most investors’
holdings. Over the past 10 years, for example, CTAs
have demonstrated no correlation to stocks and
bonds, registering -0.07 and 0.13, respectively, to
the S&P 500 and Lehman Aggregate Bond Index.
This decorrelated return stream can lessen overall
portfolio volatility and recent history has shown
that CTAs can fare well during the most troubled
times for the broader markets. They have, for
example, posted positive results during - eight of
the 10 worst and 12 of the 20 largest - monthly
declines for the S&P 500 over the past decade.
Because loss from exposure to the stock market
is generally the largest contributor to a typical
investor’s drawdown, it follows naturally that CTAs
have delivered some level of portfolio insurance to
many investors who have embraced them.
A simple analysis of the impact of adding a 10%
allocation to CTAs to a stereotypical institutional
portfolio made up of 35% equity and 65% fixed
income establishes striking results. The portfolio,
which includes CTAs, had significantly improved
risk-adjusted returns over the traditional stock
and bond portfolio with an increased return of
almost +1.5%, reduced volatility of more than
-0.5% and a +15% improvement in Sharpe Ratio
over the past 10 years.
The same assessment, but limited to the financial
crisis of 2008 (January 2008 through February
2009), reveals that although the CTA allocation
was insufficient to swing the portfolio near
profitability, it did diminish drawdown by -3% and
shaved off about -1.25% of the overall volatility.
Because CTAs were profitable - seven out of
the 10 worst and 11 out of the most difficult
20 - months for the hypothesised portfolio, their
inclusion greatly improved the overall result. THFJ
ABOUT THE AUTHOR
BEN FUNK
Ben Funk is an investor, entrepreneur and
senior advisor to investment management
firms. Previously he was a founding member of
Liongate Capital Management where he served as
Managing Director until his retirement after the
firm’s acquisition by Principal Global Investors.
Funk has been named by Institutional Investor as
a “Rising Star of Hedge Funds” and is a regular
contributor to the financial press. Funk was
formerly at Morgan Stanley. He earned a Bachelor
of Arts from Purdue University and was awarded
his Master of Research and PhD from London
Business School.
“Commodities
managers
may benefit
from a distinct
advantage over
their equity and
fixed income
peers – that is
they seem to
have a credible
information
advantage.”