Remarkable as the past 18 months have been, commodity markets continue to gyrate in ways that catch the attention of politicians and regulators. At the same time, many investors look to these markets to diversify their portfolio. There are so many things going on that it is hard to get a coherent picture.
"The outlook for commodities remains very interesting," says Global Advisors in a commentary. We asked Daniel Masters, co-founder of Global Advisors and former head of energy trading at JP Morgan, to review recent developments and what these may mean for futures investors.
Capital inflows from commodity indexes and exchange traded funds have become a major factor in the markets. Mr. Masters discusses the implications of this for investing.
He started his career at Royal Dutch/Shell, where he managed a portfolio of North Sea crude. He moved to Phibro in 1987 and led the firm's entrance into the electricity market. In 1994 he joined JP Morgan, where he established a proprietary trading program prior to being named head of the global energy trading business. Russell Newton and Mr. Masters started Global Advisors in 1999.
Opalesque Futures Intelligence: How do commodity ETFs relate to futures markets?
Daniel Masters: The general investing public was sensitized to commodity prices through the events of 2007-2008 and learned to access those markets via ETFs. This allows people to get exposure to commodities in their 401(k) plan or other self-directed pension without having to buy futures. Now, some ETFs - particularly in gold and silver - are backed by the physical commodity, but the vast majority of ETFs are structured in a different way. They buy either futures contracts or some other derivative, usually swaps. So, commodity ETFs create a tremendous funnel for capital to come to futures markets.
OFI: What effect does that have?
DM: What it means is that the barriers between futures trading and stock trading are breaking down. The important point here is that the equity universe is many orders of magnitude bigger than the commodity or futures trading universe. Here is an indication of how big the equity market is relative to commodity markets. The entire holdings of commodity index investors is less than the market cap of Exxon, which is just one of hundreds of oil and refining companies.
OFI: How is the commodities market changing?
DM: The capital flows are too rapid and too large to be balanced by any form of real activity. It's like a lot of people crowding into a small boat. Equity investors are just too much for the boat. The number of ETFs is increasing. I suspect the next big rally in commodities will be driven by the ETF buyer rather than the traditional futures buyer. The ETF buyer is not subject to any of the rules that the CFTC applies to futures traders.
OFI: Does that mean your models have to adapt to new conditions?
DM: Our models are specifically designed to be responsive to enhanced levels of money flow. If there is a large flow of money to a commodity market, our models will pick that up and react to it. That's a fundamental factor we've included in the system, so we don't need to make changes in the system because of ETF flows. If anything, as volumes pick up, our profitability tends to go up.
OFI: How will the political-regulatory reaction to commodity prices affect markets?
DM: I believe that in the next two to three years commodity prices are going to get so high, governments will almost certainly shut down the ETF link to commodity markets. There is too much capital that can be unleashed on the market via that route. Last year we were at the point of government getting involved. We're moving in that direction again.
OFI: If the ETF flows stopped, what would happen to commodity markets?
DM: Without the ETF money, markets would go back to where they were two or three years ago. We did pretty well then so we're not worried about that, but it will be a dramatic shift.
OFI: Early this year you removed the gating provisions contained in the terms of Global Commodity Systematic Fund, while hedge funds generally put down gates and froze redemptions. Why did you go in the opposite direction to other managers?
DM: We decided to pass on our liquidity to investors in our fund in response to investor needs during the crunch. We trade 35 commodity instruments with about 27 underlying individual commodities. These are all listed on exchanges and highly liquid.
OFI: Why is this year difficult for trend followers?
DM: Our P&L has been flat. There were two reasons for that during the first half of the year. Because our program is designed with downside protection, it is very sensitive to high volatility. When commodity markets moved wildly in late 2008 and early 2009, our position sizes came down dramatically. That's how we kept the drawdowns very limited last year during immense price reversals, even though we're a momentum trend follower. That means that when the markets stabilize, we're a bit under-invested because the models reacted to higher levels of volatility in the recent past. The other reason is that our positions became self hedging-net exposure was quite small and spread across related commodities, because the models were not picking up trends. For instance, we were long some forms of energy and short other forms of energy. So, small position size and small net exposure gave us flat returns in the early part of this year.
OFI: What's happened in recent months?
DM: In May our models sensed a significant pick-up in commodity momentum and shifted during the month from slightly short to increasingly long. May was a good month for us. June was more difficult. Markets were choppy. Our models reduced exposure somewhat.
OFI: What's the market outlook?
DM: In the intermediate term, there are two broad scenarios. The combination of last summer's collapse in prices and the general difficulty getting credit may serve to depress supply, causing prices to rise as demand recovers along with the global economy. Alternatively, commodity prices have already got ahead of themselves and economic growth will disappoint, causing them to fall again. Over the longer term, signs are pretty clear that we'll get commodity rallies. There is still a fundamental problem with the valuation of many commodities-it is still below the cost of replacement. The price of natural gas in the US, for instance, has to be higher to sustain production. Also, central banks around the world are pumping a lot of currency into markets, which can boost asset prices. People say inflation wont happen because there is so much unemployment, but commodities will go up even with unemployment. It's a matter of how much. They'll go up a lot more if the employment situation improves.
OFI: With all the volatility in the market, are investors still attracted?
DM: Commodities are very much an investor favorite right now. We're seeing tremendous interest in our commodity product. Of course, the crisis did a lot of damage to investors, whether individuals, institutions or funds of funds. Around a third of the client base has disappeared in the last 12 months. What we sense from the people who are left is that they're more cautious and want liquid investments where they will be able to get out when needed. That makes managed futures an attractive way to invest in commodities.