raw-cocoa-beans-commodity

Whether they’re up or down, you can almost always make a case for participating in commodities markets—as long as clients can stomach the dizzying moves on the price charts.

But how to buy in isn’t always so clear. “The cleanest way to get exposure is to buy the actual commodity,” notes Tim Pickering, CEO and lead portfolio manager at Auspice Capital in Calgary. “But that’s not an option for most institutional investors, let alone retail.” The reason, quite simply, is it’s impractical to take delivery of (and then resell) truckloads of cocoa, oil or pork bellies.

A common way of getting around this problem is to buy commodity producer stocks. Want oil exposure? Buy Suncor or TransCanada, or an ETF based on a basket of oil-producing companies. But this approach has shortcomings.

“When you buy an oil company, for example, you don’t buy commodity exposure cleanly. A stock of any type has beta—a correlation to the stock market. And the reality is […] resource stocks have a high market correlation,” explains Pickering.

The consequence is that, even if the commodity’s price goes up, your client’s exposure could go down if the stock market falls, dragging the commodity producer’s stock down with it.

Problems don’t end there, says Pickering. A host of business-related factors can divorce your client’s exposure from the commodity’s performance. For example, when you buy a stock, you’re also buying a management team, which may or may not perform as expected.

“If you look at all the factors in them running their business—from the risks of exploration and production to selling their goods, to managing human resources and the risks that has, [to] the acquisition of land, and how challenging that can be—all of those things factor into where that stock is going to go.”

And then there are extraneous factors that can make a stock tank, even if the commodity price is going up. Think Citron Research’s recent accusation that Valeant was engaging in dubious practices. True or not, those accusations contributed to a precipitous decline in the pharma giant’s stock. If the same were to happen with a commodity producer, your client’s exposure would likely drop regardless of what the commodity itself is doing.

The bottom line, says Pickering, is the stock can be greatly affected by myriad factors other than the commodity itself.

Futures for cleaner exposure

Pickering says futures are the best way to get commodity exposure because they offer the financial effect of owning the commodity directly without the physical burden. But futures can be intimidating for non-specialists.

Stay active

Investing in volatile commodities futures can be dangerous if you’re on the wrong side of a trend. Clients can easily get whipsawed if they try to make calls on their own.

That’s why Craig Machel, portfolio manager at Richardson GMP, advises against using index-based futures ETFs. “That index is going to be all long, all the time. I don’t think there’s an index out there that’s actively managed, and that’s actively managed both long and short. You have to be active.” It’s possible, of course, to short the index, but Machel argues only specialists who live, eat and breathe commodities should be making these calls.

That’s not to say active managers know exactly when upward or downward trends will begin or end. “They don’t know, they don’t purport to know and they don’t need to know. The model sees the trend break,” notes Machel. The better a manager’s model, the sooner he or she will see trends forming and ending.

“When equity markets were in the dumps, these [long-short funds] were doing quite well,” adds Machel. “[They’re] typically making money when everything else is falling. Where they fail is in sideways, choppy markets.” That’s because there has to be a trend to ride for these vehicles to generate returns.

Good news: clients can get their exposure through futures without you (or them) having to do the trades. Pickering outlines three main choices: The first requires you or your client to make a call on what the commodity will do, and when to get in and out. The other two leave those calls to a fund manager.

1. Long only

In this scenario, the commodity price has to go up for your client to make money. Not getting out at the right time can mean heavy losses. There are many index-tracking commodity futures ETFs that provide this exposure, either to single commodities or baskets of commodities (see “Stay active”).

2. Long-flat

This is a more conservative approach, where the manager provides long-only exposure to commodities futures. But there’s a safety net: the fund goes to 100% cash when the manager’s trend models suggest the commodity price is taking a sustained turn for the worse. This allows your client to participate in the upside with limited downside exposure.

“We want to be long a significant trend in a commodity going up,” says Pickering. He looks at each commodity separately, based on its individual merits from a momentum perspective.

There is no analysis of fundamentals, he adds. “We don’t look at market fundamentals because, if we do, what ends up happening is the asset return stream has a correlation to the stock market, and you don’t want that because you’ve got that already.”

Employing the fundamental method of making buy decisions, in other words, leads to the correlation. “If I look at fundamental information, then my actions and reactions [result in positions that] act more like stocks.”

Besides, argues Pickering, fundamental data isn’t always a good prognosticator of price movements. A commodities manager who relies on fundamentals will, for example, use supply and demand information when making investment decisions. Say the data shows demand exceeds supply; the logical inference is that the price of the commodity is poised to go up, and that it’s time to buy long. But the price could go down because reality doesn’t always follow logic, says Pickering, citing John Maynard Keynes’ famous saying: “The market can stay irrational longer than you can stay solvent” (see “Watching fundamentals”, for a different view).

So, Pickering focuses instead on “momentum factors that are not overly complex, based on a trend-following thesis: if an asset in motion is moving higher, then we believe it […] may continue to go higher and we may buy that asset.” If it later shows a trend downward, it’s time to exit into cash, which represents the “flat” in “long-flat.”

Pickering adds he’s trying to capture medium- to long-term trends, based on price data over many months.

“We’re not looking to capture intra-day moves, and we’re not trying to capture intra-week moves. So we may be in cash for a long time.”

3. Long-short

In this option, the manager still goes long when the commodity prices are trending upward, but, instead of reverting to cash when things turn sour, he or she will go short to capture the downward trend. Pickering notes these strategies tend to go beyond commodity exposure to include financial asset futures (e.g., exchange futures).

Watching fundamentals

Most futures practitioners (usually referred to as Commodity Trading Advisors, or CTAs) use a fully quantitative and systematic process, focusing entirely on momentum and trends. But about one-quarter to one-third are discretionary or fundamentals-based, says Christopher Foster, CEO and portfolio manager at Blackheath Fund Management.

“The problem for trend-following CTAs is that, since they are all trading the same persistence signal, they all end up looking alike and performing alike. So, from a business standpoint, it’s hard for trend followers to differentiate themselves. In fact, many [institutional investors] have actually started considering trend following ‘alternative beta.’ That is, for very little money, you can get a computer to do trend following for you, and not pay the hedge fund manager hefty fees.”

Discretionary managers have their own obstacles, he grants. “The problem […] is that human judgement is involved, and developing and sustaining that judgement over time is difficult
and labour-intensive.”

Notes Craig Machel, portfolio manager at Richardson GMP in Toronto: “They don’t care which direction [the trend is] going in or what the underlying fundamentals are. They don’t care about anything except for the fact that there’s a trend forming and they just want to profit from it.” He adds: “It’s [long-shorting] bond indices, currencies, energy markets, stock indices and individual commodities from livestock to orange juice—Eddie Murphy kind of things—[through] futures that are liquid all day, every day.”

Another approach

“We are not trend followers,” says Christopher Foster, CEO and portfolio manager at Blackheath Fund Management in Toronto. Not in the usual sense, at least: his goal is to identify trends that aren’t being jumped on by speculative money. “What we look for is not just an uptrend or downtrend. We’re looking for an uptrend or downtrend that is not being embraced.”

The key to his approach is sentiment data. “When a lot of people talk about market sentiment, they talk about it anecdotally. […] We’ve taken a more quantitative approach to sentiment: we actually try to measure it.” He’s looking for two patterns:

  1. Market trending up—people are bailing. “Everyone is selling into it because they think it’s a house of cards and it’s bound to come down soon,” says Foster. That’s where he goes long.
  2. Market trending down—people aren’t bailing. Not only are people not getting out of a down market, they’re buying long. That’s when Foster goes short.

His largest trade currently is precious metals. The market’s in a downtrend, but sentiment is bullish overall. “The fundamentals must be really bad,” he says, “[when] the market can continue going down in the face of speculative buying.” He believes prices will continue to drop, so he’s short. He’s also short crude oil, and long cocoa.

“Cocoa is a big position for us. […] People have invented lots of reasons to think the cocoa market’s going to come down. But there is no stronger commodity than cocoa,” Foster says, because the market continues to trend higher in the face of perceived weak fundamentals.

Tough year

It’s been a challenging year for futures practitioners, notes David Rothberg, chairman at Niagara Capital Partners in Toronto. That’s because there haven’t been many sustained trends to ride.

“A trend is basically nothing more than a price movement from A to B. And the wider the distance between A and B, the larger the opportunity set.” Consider two simple trends:

Distance between A and B is X
Distance between A and B is 10X

“When the difference between A and B is X and you capture 90% of the move, you’re going to capture nine basis points. If the difference between A and B is 10X and you capture 10% of the move, you’re going to get 10 basis points. So, you have to be much less accurate if you have a broad trend,” explains Rothberg.

Distance between A and B is X

90% of X

Distance between A and B is 10X

10% of X

Not only are there few large trends, there are few trends overall. Fewer available trends to play means greater accuracy’s needed to generate target returns, says Rothberg.

Why such slim pickings?

One of the most important reasons, argues Rothberg, is the zero-interest-rate policy around the world, and especially in the U.S.

Macro factors, including rate decisions by central banks, have historically had no meaningful impact on the calculations of futures traders—“except today, when the Fed becomes the only macro variable.”

Rothberg explains: “The worry about what Janet Yellen is going to do [is] for the first time both imperiling the performance of stocks and [suppressing] volatility and […] trends, affecting the performance of futures.”

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Originally published in Advisor's Edge Report

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