Post-Crisis Model for Commodity Investing
We present edited excerpts from a report on commodity markets from Celent, the consulting firm. This report makes an intriguing point. Managed futures stands to become the preferred way to invest in commodities because of concerns raised by the financial crisis, argue authors Ranjit Behera and Sreekrishna Sankar, analysts at Celent Bangalore.
The commodity trading advisor model has always existed as a choice for investors but it was overshadowed by the hedge fund model, Sreekrishna Sankar told us. However, he says now that investors have realized certain critical issues in the hedge fund model, it will be easier for CTAs to raise money and managed futures assets will grow faster than before.
As the summary below makes clear, this is a qualified prediction—CTAs will need better tools to manage risk and tailor portfolios to investor needs. And the assets will flow to well-established managers with track records, so it won’t be easy for small and new firms to raise capital. Even so, this analysis points to a larger managed futures industry with greater opportunity for all.
“Though established CTAs will attract the bulk of the new capital, new CTAs can make a mark in growing sectors like emissions and freight trading.”
“Investors have already started to move towards exchanges in search of more transparency and to minimize counterparty risk.”
The 2000s saw rising demand for commodities from emerging economies, capital infusion from players who invest in commodities for returns (rather than for hedging) and phenomenal growth in trading on exchanges. A rally began in 2002, accelerated and continued until mid-2008.
Commodities attracted investment from all segments of the financial world. The major players were pension funds, mutual funds, insurance companies, hedge funds, commodity trading advisors and the proprietary desks of various investment banks. They brought financial and technological sophistication to the market.
By 2008, the global commodities market stood at $15.3 billion, with 85% of the transactions happening in the over-the-counter market (see chart).
Commodities were heavily affected by the financial crisis. Investors un-levered their positions because of the credit contraction. Even as the credit crisis eased via monetary intervention, the problem transformed into an economic crisis. This led to a drop in demand and a slowdown in world trade, suppressing commodity prices. Commodity indices and the prices for crude oil, agriculture-based commodities and metals fell rapidly.
For most financial players involved in commodity markets, huge losses seem to have been the norm. This is especially true for hedge funds, which were hit due to their high leverage. Some were forced to shut down. However, broker-dealers made decent money from the trade volume surge as many players tried to profit from the volatile markets.
One asset class that performed extremely well during this phase was managed futures. To put the relative performance into perspective, in 2008 commodities as an asset class lost about 24% and hedge funds as a whole lost around 20%. Meanwhile, CTAs gained more than 18%.
A major profit-reaping mechanism for hedge funds was leveraging in the OTC markets. That approach to profiting from commodities might well become history as governments look at the risks taken by funds and move to correct the lack of transparency. A new regulatory regime has appeared on the horizon.
We will discuss how the commodity market game will pan out in the crisis aftermath and which investment vehicles are better equipped for handling the changes.
Investing a portion of a portfolio in commodities provides an opportunity for diversification. Investors will continue to seek this mode of diversification, and investments by financial players like insurance companies, pensions and others could reach over $2 trillion.
This table shows the impact of commodity investing via managed futures on a stock portfolio. The data indicates the smoothing effect of commodity investments on the overall portfolio, with decreases in both volatility and downside deviation.
World Stocks With and Without Managed Futures
In terms of assets under management, pension funds are the largest segment of commodity investors – with total assets of around $30 trillion under their control – followed by mutual funds. Big pension funds like CalPERS and BT Hermes have been active investors in the commodity market. Banks’ treasury departments have also made forays into commodity investments.
For most players commodities are a recent addition to their portfolio and hence form a small portion of total assets.
The industry consensus is that a 3% to 5% portfolio exposure to commodities will be ideal for diversification. On a conservative estimate, a 3% asset exposure of major buy-side players may result in $2.4 trillion of investments into commodities over time.
CTAs as Model for the Future
Investors routing money into commodity markets via hedge funds are asking for more transparency and real time investment data. Demands for independent third-party valuation of the portfolio and analysis of risk are also on the rise.
CTAs fit the bill perfectly for providing better information on investments as well as greater liquidity for withdrawals. Hence CTAs could be seen as a preferred means to get exposure to the commodity market.
Moreover, CTAs have long been regulated. We believe that CTAs’ transparency and adherence to regulatory norms helped them weather the crisis and will make them a model for commodity investing in the post-crisis era.
But their 2008 favorable performance on its own will not be enough to significantly lure investors. CTAs will have to adapt to the newer compliance regimes and upgrade risk management systems. They will have to work more closely with their clients to understand the risks that are important for each client.
There is already a trend in this direction. CTA offerings have been evolving to address investors’ demands for products tailored to reduce risk. Many CTAs try to uncover investment opportunities to best suit the clients’ concerns. This trend intensified after the slump in the commodity market.
CTAs will need better tools to assess the risks and better ways to mitigate them. They have to rapidly upgrade their technology to accommodate greater trading traffic. Viable technologies need to be developed to accommodate alternative trading systems.
The managed futures industry is fragmented. There are more than a thousand CTAs operating, with $160 billion managed in commodity-related futures. The increased flow of money should give enough breathing space for all to survive, though players with proven track records will attract the bulk of new investment.
New CTAs wishing to enter the market will have to struggle, since most investors prefer managers with established records. Though established CTAs will attract most of the new capital, new CTAs can make a mark in growing sectors like emissions and freight trading.
Move to Exchanges
Around 85% of commodity transactions occur on the OTC market because big commodity hedgers and investors preferred customized contacts. Owing to this high tilt towards OTC, some commodity transactions are not completely transparent and price discovery has become a major issue. The 2008 plunge in commodity prices created doubts regarding the kind of deals happening OTC and the motive behind them.
A big issue now is counterparty risk minimization. It is very likely that there will be a migration of buy side players towards avenues with lower counterparty risk, and thus volumes on exchanges will increase once the market recovers from the crisis.
Though the OTC market is comparatively large, transactions on exchanges have grown rapidly in recent years. Investments in commodity exchanges can be done via index funds or directly via derivatives. Index investments give investors exposure to multiple commodities at the same time.
The rise in index investing has resulted in higher trading volumes on exchanges globally. Both developed and developing countries actively participate in commodity trading. Over 40% of commodity trading on exchanges was carried out on US exchanges, followed by 26% in China, 17% in the UK and 7% in India.
Trading on exchanges in China and India has gained importance in recent years due to the emergence of these countries as significant commodities consumers and producers. Most exchanges concentrate on a couple of sectors. For example, the bulk of the trading on NYMEX is in energy and metals, whereas Zhengzhou Commodity Exchange of China is predominately agro based.
While exchanges barely form 15% of the commodity market, their role as price indicators has been crucial. Post crisis, exchanges and clearinghouses are expected to take a greater role. Investors have already started to move towards exchanges in search of more transparency and to minimize counterparty risk.
Since CTAs have always traded listed contracts, they face little counterparty risk and are well positioned to meet investors’ demand that exchange-listed instruments be used. By contrast, it will be a change for many commodity hedge funds to rely on exchanges and major clearinghouses. Hence managed futures is the right model on this score as well.
This table summarizes the points we’ve made.
Future of Commodity Investing