The Commodity Index Paradox

The benefits of multi-strategy commodity indexes in 2009

Originally published in the February 2009 issue

Commodity Price Indexes vs. Commodity HF Indexes
Commodity indexes have historically been liberally used in an attempt to diversify portfolios and structured notes. Indeed, it is likely that there is hardly an institutional portfolio that doesn’t have exposure to some kind of commodity index thesedays and it has of course, been quite easy to derive positive returns from these positions in the bull market of the past five years. But the conditions of the last six months have finally succeeded in separating those who had diversified smartly within the commodity universe from those who simply just jumped on the bull train without much thinking. As some commodities have fallen up to 80% from their peaks in 2008 they have also pulled the corresponding price indexes with them. Have individual commodity hedge funds done any better? Not necessarily. Some long/short equity managers, for example, have also lost 60%-80% in this sector, meaning that it got very ugly quite quickly for many investors. Lack of diversification and non-correlation was an extreme paradox to the return expectations.

Correlations close to 1
Today investors cannot continue to rely on the idea that exposure to a commodity price index provides the anticipated non-correlated diversifying return stream to an institutional portfolio. In the recent crisis, when diversification was needed most, commodities have started to correlate to stock and bond markets and once again investors have had to understand that investing in a bucket of commodities, such as a commodity price index, may not provide the expected diversification and non-correlated exposure that they anticipated. Unless investors are seeking pure commodity beta, they will now have to rethink their commodity investment approach. Furthermore, investors are penalized by the constant contango structure of commodity futures as well as historical sector cyclicality. True portfolio diversification means covering a broad set of uncorrelated return factors and that kind of superior diversification can be achieved using sector specific multi-strategy commodity hedge fund indexes such as the Gardner MacroIndex family of commodity indexes.

A big commodity universe

It is important to see commodities as a valued diversifier in any portfolio but in my view this diversification needs to be both long and short across the entire value chain of commodities in order to achieve such a goal. A passive long-only index exploits merely a small part of the commodity universe and as a result exposes investors to high volatility and major risks on the downside. As all commodities have a supply chain why wouldn’t investors want to invest in the entire commodity matrix?
Given that commodities are a rather new theme for many investors, they typically start with long-only exposure for several reasons: (a) the bull run of the last five years and (b) the long-only background of many investors. However, I believe that this ignores a significant portion of the available investment space.

The commodity market has evolved tremendously over the last eight years with a multitude of new index products available to investors and raft of new commodity hedge fund managers. Today there are over 680 commodity managers to choose from in the market with over $200 billion in assets under management. Their range spans different strategies, sectors and instruments. There is no other market sector which allows such a broad classification of managers in the different peer groups as exist in commodities. While there are many commodity diversified managers from which to choose, there are also many specialized sector managers (i.e. those who focus on a particular part of the commodity value chain or particular commodity) who have captured valuable strategic knowledge of some of these sub-sectors and allow access to them through their trading programs.

Numbers speak
Fig.1 shows how the overall commodity hedge fund universe monitored by Gardner has outperformed a variety of long-only indices. A simple cross-section of the commodity hedge fund universe already demonstrates their ability to significantly outperform the long-only indices.


Gardner Commodity Hedge Fund Indexes

Gardnercreated a suite of seven investable commodity hedge fund indexes in its MacroIndex family which are established as benchmarks. Each index is designed to provide a global macro view on the various natural resource markets by looking at the performance of carefully selected and rated underlying hedge funds in the respective sector.

The hedge funds in each index are selected by Gardner using defined and objective quantitative and qualitative criteria and the index value is calculated monthly using the pre-formulated objective index calculation rules. Smart commodity diversification improves a portfolio’s risk matrix and the seven Gardner MacroIndexes, by uniquely referencing hedge funds in various sectors and strategies of the natural resources space, provide an alternative view of prospective returns from this asset class.

The seven indexes Gardner tracks are in energy (GEMI), power (GPMI), shipping (GSMI), agriculture & livestock (GALMI), minerals & metals (GMMI), green (GGMI) and macro commodities (GCMI).

By using our approach of seeking exposure to all aspects of the sector including along the sector value chain and across all available strategies, we can successfully reduce overall volatility and risk for the investor while providing true diversification. To illustrate the value of commodity sub-sectors through hedge funds, two of our indexes are compared against long-only indexes; the Gardner Shipping MacroIndex GSMI (2008 +4.17%) and the Gardner Power MacroIndex GPMI (2008 +1.06%). We think that the numbers speak volumes to realize where the future of markets is and will be.

Under current and future market conditions, commodities continue to offer a diversification opportunity for investors. However, investorsmust approach commodities more cautiously than they have done in the past and must either do so from a position of improved knowledge of how the sector works or via the investment guidance of someone who does. We believe that Multi-Strategy Hedge Fund Indexes, like the Gardner MacroIndex family, offer investors an approach to commodity diversification which reduces volatility and downside risk.

Gardner Group has been providing the market with innovative investment products since 2001, and from 2004 has been offering a multi-strategy, multi-product platform that covers a range of financial solutions in the core market sectors of the commodity asset class. It acts as an institutional investment adviser to funds of hedge funds, multi-manager platforms and single hedge funds in the energy and natural resources sector. It is also the index calculation agent for a variety of commodity indexes.