The Bloomberg Commodity Index finished July down 12% YTD and 28% over the last 12 months. It is currently 60% off its highs in June 2008 (remember $150 oil?). Several large commodity funds closed in July. Does this asset class make sense? Our answer – absolutely YES – but commodities aren’t stocks so let’s stop benchmarking and investing in them the same way.
Let’s review the current bear market a bit (we will use the Bloomberg Commodity Index for illustrative purposes) and compare it to historical bear markets. If you look at the current period, beginning in May 2011, the market is off 47.6%, similar in size to historical bear markets.
|5/11 – 7/15||-47.6%|
|7/08 – 2/09||-54.3%|
|1/01 – 1/02||-20.1%|
|6/97 – 2/99||-36.2%|
|Bloomberg Commodity Index|
Where did this bear market come from? Simple – high commodity prices up through mid-2008 stimulated a supply response and demand (think China) did not keep up. Agricultural markets improved yields and expanded acreage, particularly in South America. Copper mining expanded. Fracking and the U.S. production boom put OPEC out of business. On the demand side, China slowed, the U.S. is only growing at a moderate pace, and Europe is still struggling with its own issues. This is normal commodity behavior. Fundamentals matter, high prices beget more supply, low prices beget more demand. Bull and bear cycles are expected. In fact, bull cycles have produced great returns historically.
|3/09 – 4/11||66.0%|
|2/02 – 6/08||214.3%|
|3/99 – 12/00||70.6%|
|1/92 – 5/97||80.2%|
|Bloomberg Commodity Index|
Is there a risk premium buried in all this volatility?
Let’s start at the beginning – commodities are NOT stocks. The futures market (the oldest and primary vehicle for trading commodities) was not created as a means to invest in commodities. It was created to allow businesses with commodity price risk to transfer that risk to investors. Think of a corn farmer that wants to sell forward his crop, or General Mills who want buy forward its corn supply. It is the investor who steps in, and for an appropriate risk premium, makes this a market. He earns this premium on both the long and short side as the hedging businesses exist on both sides of the market.
Let’s take a step back and consider what this means. If prices are stable, there may not be much premium for the investor to earn as businesses will have less need to lock in prices. Conversely, when prices are volatile, the premium available to the investor will be higher. Consider how that fits with other asset classes. Stocks hate instability and volatility – commodity futures investors love it. Stocks love stability – commodity futures investors don’t. Sounds like a good match.
Many investors enter the commodity markets with simple goals, diversification and inflation protection (or hedging actual future expenditures). The S&P GSCI is too heavily weighted to energy – not matching up well with hedging actual future expenditures. The Bloomberg Commodity Index has better, more equal weightings, but like the S&P GSCI is long always (remember commodities aren’t stocks). These indices do not allow you to capture the nuanced supply and demand environment for each specific commodity.
Our MLM Commodity Index was designed (in 1988) to capture the investor risk premium in the futures market and to treat each market individually. It was not designed like a stock index (a long basket of prices), it was designed to capture the economics of the market. The Index recognizes that these markets move in cycles and it takes long and short positions to reflect that. Additionally, the MLM Commodity Index Long/Neutral was designed to capture the same risk premium on only the long side of the market. This implementation seeks to provide inflation protection in bull markets, but understands that these markets move in cycles and appropriately protects the investor by removing exposure during bear markets.
Commodity markets are a great investment when understood. An investment approach that attempts to replicate the economics of the futures market produces a diversifying return that pairs brilliantly with stocks and other traditional investments.
The BCOM is composed of futures contracts on physical commodities. It currently includes 19 commodity futures in five groups. No one commodity can comprise less than 2% or more than 15% of the index, and no group can represent more than 33% of the index (as of the annual reweighting of the components).
The S&P GSCI Commodity Index is calculated primarily on a world production-weighted basis and is comprised of the principal physical commodities that are the subject of active, liquid futures markets.
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