Following weaker investor activity in 2011, investment flows into commodities rebounded in the first quarter of 2012 with $6.9 billion in fresh inflows into the asset class. As a result, assets under management in the commodities markets totaled $435 billion, an all-time high. Commodities exchange-traded products (ETPs) have continued to be one of the fastest-growing ETP asset classes, due in part to price increases that have occurred over the past few years. In 2011, commodities ETPs saw net inflows of $10 billion, bringing total assets to $152 billion.
Unfortunately—and to the chagrin of many investors—products linked to commodities indexes often experience much lower returns. Negative roll yield (which occurs when distant delivery prices exceed near-delivery prices) means that many investors lost out even as prices rose. In response, a growing number of commodities investors are eschewing the traditional long-only approach in favor of alternative strategies that are better able to manage roll yield.
With the rise of more innovative strategies, there is reason to question how well investors are being served by the traditional long-only commodities indexes as either benchmarks or proxies for investment products. Traditional approaches to representing pure beta exposures work well for stocks and bonds but not so well for the commodities "asset class." In fact, we argue that there is no such thing as commodities beta. Moreover, we assert that new passive strategies that use a momentum-based long/short approach rather than the long-only approach of the most common commodities indexes are better benchmarks for active strategies.
No Such Thing As Commodities Beta
For many asset classes, it is very easy to take a pure beta exposure—multiple asset class proxies are available, many of which are reasonable substitutes for each other. The Russell 3000, S&P 500 and Wilshire 5000 indexes, for example, are representative of the broad stock market and have similar performance characteristics, just as the Citigroup Broad Investment-Grade (BIG), Barclays U.S. Aggregate and Merrill Lynch U.S. Domestic Master bond indexes mirror the wider fixed-income market and perform alike. Yet for commodities, fewer choices and more disparity exist among the index options.
Figure 1 illustrates the similar risk and return characteristics of the broad stock and bond indexes, and the disparity among the three traditional commodity indexes—the S&P GSCI Commodity Index, the Dow Jones-UBS Commodity Index and the Reuters/Jefferies CRB Index. When we plot standard deviation and compound annual return for each index over a common time period (February 1991 to December 2011), we see that the nearly identical risk and return characteristics of the stock and bond indexes place the plot points on top of one another. The commodities indexes, however, do not display the same level of consistency. Dramatic differences in constituents and weighting schemes as well as rebalancing rules are likely the cause of the performance differences in the commodities indexes. The S&P GSCI Index, for example, has about double the weighting to the energy sector as the Dow Jones-UBS Commodity and Reuters/Jefferies CRB indexes and only one-third of the weighting to agriculture.
However, these indexes all reflect long-only commodities futures strategies, which can prove inadequate in providing investment exposure to commodities. As a result, professional commodities trading advisors tend to take both long and short positions in commodities futures, often based on trends in prices.