Battling the benchmark

The battle between investment banks and index providers for the title of whocan create the most efficient commodity indexes has been underway since thelatest commodity bull run took hold in 2006.

However, investors soon learned that roll yield can split indexes from the spot price of the commodity they are designed to track. When commodity curves steepen, it becomes increasingly expensive to roll into a new futures contract each month, which eats into returns. As climbing prices attracted increasing attention during the commodities upswing, providers flocked to launch roll-enhanced indexes and strategies that tackled short-term curve exposure, diversification and volatility.

In the past, investors had always turned to well known benchmark indexes such as the Dow Jones UBS Commodity Index and the Standard & Poor's Goldman Sachs Commodity Index (GSCI) to get their statutory slice of portfolio diversification.

But no provider could have anticipated quite how badly the asset class would perform last year. The Rogers International Commodity Index (Rici) has fallen 44.5% over the past 12 months - nearly double the fall in the S&P 500 index during the same period. S&P's showcase commodity index - the S&P GSCI - turned in an even worse performance, plummeting 56.5% in the same period, partly as a result of its heavy energy weighting of around 70%.

Nor was the GSCI immune to demand for more tailored indexes. It is now available in around 80 different versions, including the enhanced index, a one-to-three-month futures version and an 'energy light' version. Despite this, the S&P one-to-three-month forward strategy indexes did little better than their commodity benchmark, with the average drop of the three indexes at 51.5% over the 12 months to the beginning of July.

S&P stands by the index's heavy energy allocation, which is the result of its uncapped production-based weighting. "If the price of energy doubles or triples, it is going to impact your life exponentially, so I think that it is a much purer way to get exposure," says Mike McGlone, director for commodity indexing at S&P in New York.

Roll yield is something McGlone views as a type of insurance which must be paid in a commodity index. "Commodity indexing has proved that you can provide some insurance for commodity or energy-type shocks. In the longer term, this insurance has not really cost too much," says McGlone.

The S&P GSCI has been running since 1990, which has contributed to its allure as a traditional product, as has its association with a high-profile index provider since 2007. Its nearest rival, the Dow Jones UBS Commodity Index, was unfortunate enough to be previously associated with one of the major protagonists of the financial crisis - American International Group (AIG) - until its purchase by UBS in May 2009.

The Swiss bank appears to have been successful in the rebranding and transition of the index, and has re-licensed more than 65 providers. "We have made no changes to the index - the name has changed but the methodology remains the same," says Jeffrey Saxon, director in UBS's commodity indexing business in New York. UBS also offers one-, two- and three-month forward versions of the index. "There's a sense that interest has been increasing recently, and I'd say we are getting some traction on those indexes," says Saxon. At the beginning of July, the DJ-UBS Commodity Index had fallen 47.7% over the previous 12 months.

The question is whether the more sophisticated indexes designed to beat benchmarks at the height of the market succeeded in outperforming them on the way down. The answer is yes, but only to a moderate degree. One of the first to market in January 2007 was the UBS Bloomberg Constant Maturity Commodity Index (CMCI). The index uses 28 futures contracts to extend exposure beyond the short end of the curve, mitigating roll yield and supposedly offering lower volatility than the benchmarks. The CMCI fell 34.7% in the 12 months to late July.

Later in 2007, JP Morgan launched its Commodity Curve Index (CCI), which soon hit the headlines via a legal wrangle after BNP Paribas unveiled a similar version of the same index on the same day, which it later withdrew. The CCI distinguishes itself by the number of commodities it includes, with 35 components - weighted by open interest rather than production -spread across baskets of different maturity futures contracts. The beta index has fallen 44.5% over the past 12 months.

"We feel that JPMCCI is a more robust benchmark as it is more representative and exhibits better roll characteristics," says Eynour Boutia, head of product development for commodities at JP Morgan in London.

Benchmark investment is still attracting attention, but investors are increasingly looking beyond long-only passive exposure. Since 2005, JPMorgan has operated its Commodity Igar dynamic strategy index, which allocates positions based on momentum signals. The index is available in several versions - the long-only strategy has lost 15% in the past 12 months, while the long-short version has decreased 2% during the same period.

"I would say today's market is fairly balanced," says Boutia of the appetite for alpha and beta. "We receive a large number of enquiries for enhanced beta from clients who are bullish on commodities, but it would be safe to say that we see an equal number of requests for alpha strategies from non-benchmarked players."

Absolute returns

Investors have not only learned the lesson of a painful drawdown, but have also been hurt by correlation. Many, particularly those in the institutional space, turned to commodities for diversification. However, while the asset class can provide a hedge against major asset classes, this strategy only holds water during periods of inflation. In a deflationary environment, commodities tend to sink along with everything else. The trickle of more sophisticated methods of exposure down to the retail market is therefore hardly surprising.

The longer that investors are involved in commodity market bull runs and possible drawdowns, the more evident becomes the potential divergence in individual performance. As a result, long-short absolute return strategies based on commodities appear to have survived better than most.

Royal Bank of Scotland's (RBS) market neutral strategy, which is part of the bank's research-based CYD Neutral family, holds simultaneous long and short positions for each commodity, with different expiration dates on each contract. It also looks to sell short-dated futures contracts which positions the strategy as a liquidity provider where there is strong investor demand. Twelve-month performance has been 1.2%, and 100-day volatility is extremely low at just over 2.5%.

"The key point is that volatility of the CYD MarketNeutral Index is minimal as it is market neutral," says Laurence Black, head of thematic indexes at RBS in London. "We have raised about $2 billion on the index, from mostly institutional investors in Europe and Asia." The other benefit of the index has been its zero to negative correlation with other indexes, given that correlation is now a high priority. The bank has also recently teamed up with investment expert Victor Sperandeo to launch the Trader Vic Index, which is mooted as another investment that is non-correlated to equities and bonds. The index uses moving averages to determine whether to take a long or short position on various sectors, and avoids pure commodity exposure by including weightings for bonds, rates and foreign exchange.

The next distinguishing characteristic between strategies could be the various overlays used to determine trends, rather than how the strategies mitigate roll yield, how many commodities they include, how weightings are allocated or what positions can be taken.

In April 2008, BNP Paribas launched Comac, a proprietary long-short strategy which uses its own systematic algorithm to allocate positions to different commodities based on signals from Tiberius Group. The total return version of the index has gained an impressive 29.3% over the past 12 months. Oscillator Commodities, on the other hand, is the bank's long-only momentum-driven strategy, which allocates positions to various sub-indexes. The total return index built around the strategy has lost 7.9% in the past year, with around half the level of 100-day volatility of Comac.

Even without the potential to short, the merits of dynamic allocation and variable weighting are evident. The underlying sub-indexes of the Oscillator strategy are taken from the DCI BNP Paribas Enhanced, an optimised roll index which was constructed in partnership with Diapason Commodities Management in 2006 on the back of uniform contango across commodities markets. The aggregate version of the beta index itself has lost 38.5% over the past 12 months. The Oscillator's 7.9% loss was achieved from the same building blocks.

"Nowadays commodity curve optimisation is well-established and well-understood by investors. Every house or investment bank is proposing some kind of commodity investment with enhancement on the curve," says Jean Guillaume Caruba, London-based commodity products specialist at BNP Paribas. "But getting a better roll return on the curve, while necessary, is not enough and dynamic allocation into different commodities and sectors has become the new frontier. Commodities are diverse and will produce different returns over time according to their own specific fundamentals. Being passive in weight allocation, even long-only, is not an option anymore," says Caruba.

Even though dynamic exposure is more expensive than passive investment, the outperformance outweighs the additional costs. Fees for Oscillator, for example, are at around 50 basis points, yet it has consistently outperformed its benchmark by far greater.

"I think there has been a noticeable shift in focus for investors of all types - from pension funds to retail investors - from the original commodities as an asset class story which was primarily about diversification, to becoming much more return oriented," says Kamal Naqvi, head of commodities institutional sales at Credit Suisse's in London. The shift is a result of the spike in correlation between commodities and other asset classes over the past 12 months, says Naqvi. "It's no longer sufficient just to say that you need to put a certain percentage into commodities as a diversifier, you need to be able to show an approach that is likely to make clients money - I think that's a noticeable development and clearly a reaction to the last six months of 2008"

Credit Suisse is launching itself into the commodity index space with some force. Part of its new offering will include the resurrection of a benchmark index originally published in 1978. The bank has also launched several new offerings outside of the beta space. "With the reduction in prices last year, a growing proportion of investors now want less of a directional bet on commodities and are targeting a positive absolute return over time," he says.

It is unlikely that this marks the beginning of the end for traditional benchmark commodity investing. The perceived potential of the business is shown by the speed with which AIG found a buyer for its commodity index business, which appears to have made a successful transition to its new home. In addition, some investors are restricted to beta exposure or prohibited from shorting by their mandate or internal regulations.

But many investors are certainly beginning to appreciate the subtleties of divergent performance and how to protect themselves from serious downturns. And as providers pile into the commodity product space investors are being offered an increasing number of ways to take that exposure.

"New money is tending to go into new products, rather than the traditional long only, passive indexes," says Naqvi. "It is now very rare that I will speak to a client who is not invested in commodities and their first step is to go into traditional exposure like the S&P GSCI or the DJ UBS. Now people are likely to pick something dynamic".