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I appreciate the supply and demand of returns methodology you use in your month Asset Class Valuation Update. However, I'm still struggling with how it applies to commodities, and in particular how the equilibration process works. Could you please explain this again?
The supply of returns from a commodity futures-based index comes from four sources. Since futures can be purchased at less than their face value, excess cash is invested (e.g., in real return bonds) to generate returns. There is also a diversification return that comes from investing in a range of commodities (e.g., energy, agricultural and metals) that have low correlations of returns from each other. The third source of return is the so-called "roll yield" that is earned when futures contracts nearing maturity are sold, and the proceeds used to replace them with longer-dated contracts. When futures prices are "backwardated" (i.e., near dated futures prices are higher than longer dated prices), the roll yield is positive; when prices are contangoed (near term prices are lower than longer dated prices), the roll yield is negative. The final source of returns is unexpected changes in the price of the commodity (i.e., price changes that the seller of the contract has not assumed when transacting with the buyer).
Let us now assume a situation like past two years, when the economy was rapidly growing. This caused a tightening of the supply/demand balance for many commodities. In turn, this raised the probability that price surprises would occur (e.g., a positive surprise in the case of an unexpected supply outage, or a negative surprise if demand growth was less than expected). It also raised the premium on having access to physical commodities. When the supply/demand balance is slack, a company that uses a commodity has the choice of either buying, financing, and storing it, or buying sufficient futures contracts that can be exchanged for physical products. Logically, all else being equal, the price of the futures contract should equal the spot price (i.e., the cost of buying the commodity today), plus the cost of financing the purchase and storing the physical product until it is used. However, when supply/demand conditions are tight things change, particularly when there are high costs associated with running short of the commodity in question. Under these conditions, owning the physicals, rather than taking a chance on something going wrong with the delivery of a futures contract, and/or having more flexibility to vary production by using the stored physicals, may seem a more prudent course of action to take. Hence, users of commodities, when supply and demand are tight, may bid the spot price up higher than the futures price, producing a "backwardated futures curve" - and profitable roll yields for investors in commodity futures-based index products (technically, this is known as the "convenience yield" effect).
So far, so good. Now let's consider the dynamics underway on the supply and demand sides of this market. On the supply side, rising prices will lead to investment in new capacity. And on the demand side, rising prices will lead to searches for more efficient processes and substitute products. Eventually, this will result in a shift in the supply/demand balance, unexpected falls in commodity prices, a shift from a backwardated to a contagoed futures curve, and negative roll yields. But that's not the end of the story.
As we have seen over the past two months, falling prices cause new projects to be canceled, that sets in motion a tightening of the supply/demand balance. For example, the most recent "World Energy Outlook" from the International Energy Agency cautions "globally, oil resources might be plentiful, but there can be no guarantee that they will be developed quickly enough to meet the level of demand projected in our Reference Scenario...The projected increase in global oil output hinges on adequate and timely investment. Some 64 million barrels/day of additional gross capacity - the equivalent of almost six times that of Saudi Arabia today - needs to be brought on stream between 2007 and 2030. Some 30 mb/d of new capacity is needed by 2015. There remains a real risk that under-investment will cause an oil-supply side crunch in that timeframe." However, while falling prices cause cancellation or delay of new supply side investments, they also cause consumption (say, of gasoline) to rise. Eventually, the supply/demand balance tightens to the point that positive price surprises and backwardated futures curves reappear. Through this complex set of processes, the supply of and demand for returns on the commodities asset class are constantly attracted to equilibrium, even if they seldom attain it. A further issue (which is covered in this month's Product and Strategy Notes) is the extent to which rising investor interest in commodity futures may have changed the operation of this adjustment process. For example, did a spike in futures buying by investors attracted by the upside price surprises in early to mid-2008 more than offset the convenience yield effect, and produced an unprofitable contango instead, while also creating more upside price surprises? While this issue remains unresolved, it does hint at a change in the adjustment dynamics that could produce much more volatile commodity returns. On the positive side (and as discussed in this month's Product and Strategy Notes), it should also offer lead to the development of new products that offer better ways to invest in commodities investors.
I'm having a hard time figuring out how the Dow Jones AIG Commodities Index is constructed, and whether it keeps up with inflation. If so, what are the implications of this for assessing the value of this asset class using current prices compared to the distribution of historical index values? Finally, when it comes to commodities, there is one key issue I have never been able to reconcile in my mind - at the aggregate level, surely this is a zero sum game. So if a diversified basket of commodities futures in fact offers equity like returns, the question is, why would anyone sell them?
Thank you for a great question. The weight of different commodities in the DJAIG is based on a combination of their relative liquidity and production volumes. These weights are multiplied by the current price of so-called "designated futures contracts" to get the daily value of the index. DJAIG values are reported in two ways: (1) the excess returns index is based only on roll returns and price changes in the underlying futures contracts, while (2) the total returns index includes the returns on underlying collateral (which is assumed to be U.S. Treasury Bills; however, some product providers invest their collateral in other products - e.g., PIMCO uses U.S. real return bonds, which they believe provide a better inflation hedge, consistent with the purpose of commodities in many investor portfolios). More information about the DJAIG methodology is available.
With respect to your query about whether the DJAIG has kept up with inflation, we calculated the real return on the DJAIG excess returns index between 1992 and 2007 (using U.S. CPI as our measure of inflation). Over this period, the average annual real return on the index was 4.6%, with a standard deviation of 16.8%. Over the full fifteen years, the compound annual real return was 3.1% (which is in line with the general rule of thumb that the compound annual return is equal to the arithmetic average less half the variance - which is the standard deviation squared). So, to answer your question, over the period we analyzed, the returns on the DJAIG in fact exceeded the rate of inflation.
On the subject of the impact of this on our valuation judgments, we are the first to admit that our comparison of the current DJAIG index level with a normal distribution of historical index values is only a rough indicator. The question we have always asked was how much the accuracy of our estimate would improve as the result of using inflation adjusted index returns in our analysis, and perhaps making assumptions about the impact of new commodity market dynamics on the shape of the distribution we use. At least in 2008, we decided that this wouldn’t have changed our conclusion that commodities were probably overvalued; as a result, we invested our time in developing an alternative valuation model for commodities, based on our supply of and demand for asset class returns framework. That said, we continue to pursue improvements in this area.
Your last question - why would anybody sell futures if buying them generates a long term return premium over real return bonds - gets us back to the underlying dynamics of commodity markets. As we have noted in the past, they are complex, to put it mildly. Based on our reading of the research, at least four different underlying processes are at work. The original purpose of commodity futures markets was to enable product producers to lock-in the price of their output, and product users to lock-in the cost of their inputs. Since the desired purchases of these two groups were not always in balance (e.g., during a period of falling price, there would be more producer interest in selling futures than user interest in buying them), a role was created for liquidity providers, who would take the other side of these trades (for an anticipated profit) to eliminate the imbalance. In terms of futures curves (with price on the vertical axis, and time to expiration - arrayed from near to longer term - on the horizontal), this "hedging pressure" theory would generate downward sloping (i.e., backwardated) futures curves when prices were falling, as producers want to sell more contracts than users want to buy, and upward sloping (i.e., contangoed) curves when prices are rising.
The second process is driven by the costs users bear when they run out of a commodity, and what it costs for them to buy and store it. When supply and demand are tight and prices are rising, users may fear running out of a product, and hence place a higher value on owning inventories of physical product than they would when markets have more slack. Hence, they will bid up the price of physical commodities (i.e., the "spot price") relative to futures, causing the futures curve to become backwardated. In contrast, when supplies are plentiful, users would rationally tradeoff the cost of buying a commodity at spot, and then storing it until it is needed, or buying a futures contract. In an efficient market without the opportunity for arbitrage profits, the futures price would equal the spot price plus the user's storage and financing costs - in other words, the futures curve would be contangoed.
As you can see, these two theories produce diametrically opposite predictions about the shape of the futures curve when prices are rising or falling. On balance, the evidence seems to favor the theory of storage, at least in terms of its impact on prices (it seems hard to believe that the hedging pressure process is not also underway). However, two other processes also affect prices, and these are driven by financial investors, not the producers and users of commodities. Active investors (ironically known as "speculators" in traditional writing about commodity markets) buy and sell futures contracts in order to profit from what they believe are their superior forecasts of future commodity prices. Their activities introduce new sources of supply and demand in the futures markets. More important, since trend following (i.e., momentum) is a popular basis for these active strategies, the rising percentage of market trading volume driven by these active managers has probably caused a fundamental change in commodity market dynamics. Research on the application of complex adaptive systems theory to financial markets (e.g., see multiple papers by Blake LeBaron or Cars Hommes) has found that they are reasonably stable and efficient when investors who use "fundamental value" strategies (traditional producers and users in our commodity market example) are the dominant players. However, as more and more trading is driven by momentum strategies, market prices become less efficient (i.e., they do not stay as close to fundamental values), more volatile, and characterized over time by a rich ecology of complicated boom and bust cycles. Most recently, a fourth process has also become a more powerful influence - an increased buying of futures contracts by commodities index funds. All else being equal (which it clearly isn't) this should put upward pressure on futures prices, relative to spot prices, and thereby raise the probability that the market will be in contango.
With a better understanding of the complex dynamics underway in today's commodity markets, we can better answer your question about why someone would sell a futures contract. Producers sell them to lock in a price for their output. Liquidity providers sell them to earn a return from helping to make orderly markets. And speculators sell them to profit from anticipated price declines or to arbitrage inefficiencies in the relationship between spot and futures prices.
It appears that Equity Market Neutral products have had little impact on the returns of your various model portfolios. It almost seems to have had random effects; in some cases it helped, and in others it hurt. Given that, do you still believe that adding Equity Market Neutral positions is beneficial?
Yes, we do, because of a point you noted in your question: the random returns produced by equity market neutral and other active strategies whose returns have a low correlation with those on the broadly defined, passively managed, low cost index products that form the basis of our model portfolios. Mathematically, the inclusion of uncorrelated alpha strategies can raise average long-term portfolio returns while not adding much to risk. However, as you seem to imply in your question, on a year to year basis this can be frustrating, because an uncorrelated alpha product can move in the same direction or the opposite direction of the rest of the portfolio. However, this does not imply that it is a bad investment in terms of the long-term value it adds to a portfolio. In fact, some asset allocation methodologies (e.g., those based on allocating equal amounts of a risk budget to different asset classes) recommend significant allocations to actively managed uncorrelated alpha strategies.
On the other hand, we have also pointed out some limitations of this approach. First, few active strategies seek to deliver returns that have a low correlation of returns with those on multiple broadly defined asset classes (a lesson many investors in 'hedge' funds have learned the hard way this year). Second, even when you find such a strategy, you cannot be sure how long the manager's edge will last. As we have repeatedly written, the continuing evolution of the economy and financial markets can make today's superior source of information or superior model obsolete tomorrow - and there is always the chance they will be copied by other investors, who will compete away the alpha they have generated in the past. For this reason, we have in the past limited our allocation to the relatively few equity market neutral and other uncorrelated alpha strategies that have been available to retail investors. However, this is an issue we will continue to re-examine as the number of investment offerings in this category continues to expand.
Could you expand on what you mean by the term "liquidity reserves"?
Unfortunately, it seems that a degree of confusion has been created by different writers' use of terms like "emergency fund", "precautionary savings", "liquidity reserves" and similar terms. While similar, they appear to refer to slightly different concepts. An "emergency fund" is often thought of as an amount sufficient to cover normal living expenses for a given period of time (e.g., a period of unemployment) - say somewhere between three months and one year. "Precautionary savings" strikes us as a broader term that includes not only funds sufficient to cover living expenses, but also larger liabilities (e.g., unexpected health care expenses or assisted living costs). When we use the term "liquidity reserves", we have in mind an even broader concept that includes not only emergency and precautionary savings, but also savings for large purchases (which assumes reduced use of credit cards), and money taken out of one's investment portfolio because of (a) substantial overvaluation in some asset classes, and (b) no other asset classes where both current valuations and current portfolio allocations make further investment attractive. To put it differently, rather than including "cash" as an asset class in our model portfolios that is somehow different from emergency and precautionary savings, we recognize that as a practical matter all liquid assets are fungible and investors usually think of them as being in a different category than their investment portfolio.
Since May 2007 we have advocated raising liquidity reserves because we believed the coming crisis (which has now arrived) would be long and could easily involve substantial unemployment and reductions in the availability of consumer credit, and because we believed that many asset classes were substantially overvalued. We have also repeatedly noted our belief that the proper role of gold is in an investor's liquid reserves, in the form of gold coins such as South African Krugerrands, Canadian Maple Leafs, or U.S. Eagles and Buffaloes. In the case of a true economic disaster, gold coins provide a liquid store of value that is easy to use in transactions - unlike ETFs that are backed by gold (when you sell those ETF shares, you receive currency, not metal!). Beyond gold, there is also an argument, we have long believed, for holding at least a portion of one's cash reserves in another currency - a bank account is ideal, with foreign currency CDs or ETFs a good alternative. Finally, recent events have also made it painfully clear that money market funds are not exactly the same as insured demand deposit accounts at a commercial bank, and involve a greater risk of capital loss.
I am a new subscriber, and am a bit confused by the purpose of your Asset Class Valuation Update section. Are you advocating market timing?
We are the first to admit we are pragmatists, not purists! The logic behind this monthly update is as follows. First, simple mathematics shows that avoiding large downside returns is more important to an investor pursuing long-term goals than reaching for the last few basis points of return. Second, we believe that financial markets are best characterized, not as an efficient market in which prices generally reflect fundamental values, but rather as a complex adaptive social system in which, though attracted to efficiency, can still give rise to bubbles and crashes. Third, we believe that the first line of defense against large downside risks is a well diversified portfolio and a regular (i.e., systematic) rebalancing strategy (e.g., one that rebalances when an asset class is more than 5% above or below its long-term target weight). However, this systematic approach does not address the needs of an investor who needs to decide when and where to add new funds to a portfolio, nor does it address the risk of multiple asset classes simultaneously becoming substantially overvalued, and justifying a move into cash and other highly liquid assets. In both these situations, it helps to have a view on the current valuation of different asset classes, which is what we provide each month in our Asset Class Valuation Update. It is not our intent to help investors earn higher returns by providing tactical market timing inputs; rather, our goal is to provide strategic warning that can help limit downside risk exposure. To this end, we very clearly state that "this is an assessment of valuations at a given point in time, which implies no forecast as to whether and when the market's "animal spirits" will cause any over and undervaluations to reverse in the future. Bear in mind that before such a reversal occurs, over and undervaluations could actually become more extreme."