Gasoline and Coffee Fuel Our Daily Lives. Can
Commodities Also Fuel Our Investment
Portfolios?
November 13, 2015
by Bransby Whitton, Klaus Thuerbach, Kate Botting
of PIMCO
Commodities are a tangible part of our daily lives. They are the food we eat, the energy that powers our
cars and heats our homes, the metals that go into our electrical wiring and our jewelry. Yet investing in
commodities can seem elusive.
Unlike stocks and bonds, commodities are physical assets. And for the vast majority of investors,
taking delivery of barrels of oil, bushels of wheat and other physical assets is impractical. For
centuries, people have used futures markets to solve this problem; the first official exchange with
standardized contracts and centralized clearing emerged in Japan in the early 1600s. In the United
States, futures contracts on wheat and cotton began trading in the mid-1800s.
Today, commodity exchanges are ubiquitous. They give investors a way to gain or offset exposure to a
spectrum of commodity prices without having to deal with delivery and storage. They also give
investors access to an asset class that can help diversify portfolios, hedge inflation and event risks,
and provide a return potential that can be enhanced through skilled active management. In addition,
commodity exchanges offer an important service to commodity producers by allowing them the ability
to offset pricing risk or to hedge future production costs.
The case for commodities today
In the broader portfolio context, investors typically look to a commodities allocation to provide three key
benefits: diversification, inflation protection and return potential.
Admittedly, the return benefit has been questioned in recent years given a challenging performance
period. However, commodity returns tend to be cyclical, so commodities’ recent history should not be
extrapolated into the future. The past few years of commodity returns are not an aberration, but nor are
they the norm. Commodity asset class returns tend to go through cycles of positive and negative
performance, which largely coincide with economic growth cycles.
To illustrate, Figure 1 compares the return of a 55% equity/40% bond/5% commodity portfolio versus a
60/40 stocks-and-bonds portfolio. The relative performance of the portfolio containing commodities has
varied over time, with periods of underperformance during economic downturns, as expected.
Commodities as a whole are growth-sensitive assets, especially in recessions that coincide with
plentiful commodity supplies and weak demand – exactly what occurred during the global financial
Page 1, ©2016 Advisor Perspectives, Inc. All rights reserved.
crisis (GFC). Importantly, these periods have been followed by years of recovery in commodity returns
and the outperformance of the 55/40/5 portfolio. Therefore it is worth taking a longer-term perspective
when evaluating the ongoing return potential for the commodity asset class.
While the return benefit of including commodities in a broader portfolio can be cyclical over time, the
diversification benefit has remained consistently positive, which has led to better risk-adjusted returns
over time. As Figure 1 shows, the volatility of the 55/40/5 portfolio has been below that of the 60/40
portfolio during various economic cycles over the past 45 years.
The correlation of commodities to equities did pick up temporarily in the aftermath of the GFC. This
followed the decline in aggregate demand that uniformly affected many asset classes, resulting in
higher correlations among them. However, commodities have since returned to responding more to
fundamental supply factors. These can include weather, which affects natural gas and grains prices;
geopolitical instability, which influences crude oil; or mining strikes, which move metals. Importantly,
these factors do not tend to affect stock or bond market returns, and accordingly, correlations between
commodities and other asset classes have fallen. Recently, correlations also have declined among
individual commodities as the markets have emerged from the GFC. This low correlation among
commodities contrasts sharply with the generally high sector correlations within other asset classes. As
an example, Figure 2 presents a comparison of correlations across commodities sectors and
Page 2, ©2016 Advisor Perspectives, Inc. All rights reserved.
correlations across equity sectors. The fact that commodity cross-sector correlations have returned to
lower levels in the past few years is additional evidence that supply fundamentals are once again
driving commodity markets and that each commodity is responding to idiosyncratic conditions rather
than the effects of aggregate demand on the entire asset class.
Finally, commodities can help hedge a broad portfolio against inflation shocks. While food and energy
constitute approximately one-quarter of the Consumer Price Index (CPI), they drive the majority of
changes, especially unexpected changes, in inflation. In other words, food and energy account for the
majority of CPI volatility. This unexpected volatility can be especially harmful to stock and bond returns.
The commodity asset class, on the other hand, has a positive correlation to changes in inflation
because commodities drive these changes. Furthermore, commodities tend to exhibit an outsized
response to inflation – when inflation increases above expectations, commodity returns tend to
increase more than the change in the inflation rate. Thus, to the extent that inflation surprises to the
upside, a commodity allocation can provide a potential hedge against inflation beyond just the original
dollar amount invested.
Weighing investment implementation alternatives
Owning physical commodities is impractical and creates concerns about which commodities to buy and
how to pay for storage and insurance. One can invest in equity of commodity producers, but this too
comes with complications. Commodity producers may hedge away their exposure to commodity prices,
and the return on equity may be affected by the financial structure, unrelated business activities and
the talent of company management. Consider the 2010 Deepwater Horizon oil spill: Oil prices were
rising while BP’s stock price was plummeting. Managed futures strategies (i.e., commodity trading
advisors (CTAs)) offer exposure to commodity prices; however, these strategies lose some of the
Page 3, ©2016 Advisor Perspectives, Inc. All rights reserved.
advisors (CTAs)) offer exposure to commodity prices; however, these strategies lose some of the
inherent benefits of the asset class because they do not consistently allocate to a broad basket of
commodities and can shift exposures between long and short holdings.
Broad commodity indexes, on the other hand, are constructed to provide investors with systematic
exposure to commodities as an asset class. A commodity index-based investment involves holding long
futures contracts on an array of underlying physical commodities, with allocation percentages based on
global economic importance. This approach offers investors consistent long exposure to prices of a
basket of commodities, which in turn offers the potential for diversification and inflation-hedging
benefits to the overall portfolio.
The most widely used commodity indexes include the S&P Goldman Sachs Commodity Index (S&P
GSCI), the Bloomberg Commodity Index (BCOM) and the Credit Suisse Commodity Benchmark
(CSCB). Each is designed to provide the benefits of the commodities asset class but differs slightly in
construction. For example, S&P GSCI places greater weight in the energy sector, which gives it a
higher sensitivity to inflation but with higher volatility. BCOM incorporates caps on each of the
underlying sector weights and thus is more diversified. BCOM and S&P GSCI can be considered firstgeneration indexes because they hold their exposures in front-month futures contracts, and when
those contracts approach maturity they roll this exposure to the next available month during a narrow
trading-day window at the beginning of each month. CSCB, a second-generation index, holds contracts
in the first three months for each commodity and rolls this exposure over a wider trading window.
What all commodity indexes have in common is that each has predetermined rules that govern
construction, contract holdings and roll schedules. This creates predictable trading patterns that an
active commodity investor can seek to exploit.
Adding value through active management
We have established that the commodity futures markets are distinct from traditional investable assets
such as stocks and bonds, and that commodity index-based investments can offer a variety of investor
benefits including portfolio diversification, inflation hedging and return potential. In addition,
commodities offer a fertile opportunity for active management and potential for alpha generation for
capable investment managers. The three main layers of value-add in commodities are (1) structural, or
rules-based, inefficiencies; (2) commodity market-specific risk premia; and (3) in-depth bottom-up
fundamental analysis.
Structural inefficiencies
As previously described, a static buy-and-hold approach is impossible for commodities because futures
contracts must be rolled to avoid physical delivery. Most long-only investors find themselves investing
in collective vehicles where professional money managers can manage frequent rolling of futures
contracts and potentially take advantage of a number of structural inefficiencies inherent in commodity
indexes.
Optimized roll strategies. Because commodity indexes follow a predetermined roll schedule, the
precise moment when an entire passive commodity portfolio will turn over the following month is
known. Because these flows are predictable, avoiding rolling during those predetermined trading days,
by rolling either before or after them, historically has led to better execution and results. We believe this
Page 4, ©2016 Advisor Perspectives, Inc. All rights reserved.
strategy continues to be a value-additive trade.
Holding deferred contracts. Holding commodity contracts further out the futures curve than specified
in the indexes offers another structural source of potential outperformance over passive indexation.
Because commodity futures curves normally are upward sloping and the curve is steeper in the front
months, moving out on the curve may have positive implications on realized roll yield. In addition,
holding deferred contracts reduces overall volatility because front-month contracts tend to be the most
volatile.
Of course, as with any active deviations from a benchmark, it is crucial to avoid blindly implementing
structural trades without considering the fundamentals driving markets. For example, pre-rolling natural
gas exposure during early 2014 was a risky proposition because extreme weather from the polar vortex
increased market volatility, especially in the front months, thereby elevating the active risk of pre-rolling
without improving the expected returns of the trade.
Earning risk premia in commodities
Another important distinction between commodity futures and traditional asset markets is the
difference in motivations among market participants. Investors in stocks generally seek to profit from a
company’s business operations through dividends and stock price increases. Profit maximization in
commodity investing is a legitimate incentive but by no means the only or even the dominant motive of
many market participants. A large part of commodity futures transactions is undertaken by so-called
hedgers, most often representing companies that use commodities as an input or output of their
business activities. Their intention could be to offset pricing risk or to hedge future production costs.
Said differently, hedgers do not require their commodity trading activities to be profitable to gain an
economic benefit.
One recent example is hedging activity by U.S. shale oil producers. Selling West Texas Intermediate
(WTI) crude oil futures one year out hedges their price risk, and as long as they know they can
produce the oil for less than the forward price they will realize a profit and be comfortable scaling their
operations. And for the service of price protection, they are willing to pay a premium. This is a premium
that commodity investors can earn.
Note that this premium is not earned automatically by buying passive long-only exposure. As explained
above, commodity indexes gain exposure in the front of the futures curve; hedgers might be active
further out the curve. To take advantage of such flow dynamics, an active approach to commodity
investing is required.
Hedging by economic market participants offers another source of structural premia in commodity
markets. For example, weather has a high impact on natural gas demand (and also, to a lesser extent,
on production). Generally speaking, the colder the winter, the more natural gas is demanded. In fact,
the impact of weather on natural gas demand is so great that every year there is a small risk of running
out of natural gas by winter’s end. This could happen, for example, when extreme cold affects demand
and limits production, thereby leading to significant repercussions on balances and prices.
Page 5, ©2016 Advisor Perspectives, Inc. All rights reserved.
To manage this price risk at the end of the winter season, natural gas buyers (e.g., utility companies)
typically hedge their exposures by buying March natural gas futures. This way they can be sure to fulfill
their natural gas needs, no matter the spot price. As a consequence, March natural gas tends to trade
significantly above April or other post-winter natural gas contracts. The utilities are willing to overpay for
the March contract because they gain an economic benefit for their operations.
Active commodity managers can benefit from the utilities’ hedging activities. By selling the expensive
March natural gas contract and simultaneously buying the cheaper April natural gas contract, they can
profit as prices of the two contracts converge once it is certain that natural gas will not run out that
year. Figure 3 illustrates how the premium between March and April declines over time in most years.
We also see that despite the generous premium to be earned, the trade can be volatile — making a
risk-managed approach to sizing these types of trades imperative.
Fundamental analysis in trading commodities
Finally, the third layer of additional value comes from fundamental analysis. It is arguably the most
difficult to implement, but it is also the most rewarding if done right. Fundamental analysis evaluates
current and future supply and demand balances across commodities and regions to identify potential
mispricings. It requires extensive market knowledge and experience and can entail significant
resources to develop more reliable models of shifts in future commodity supply/demand balances.
As an example, fundamental pricing relationships between different crude oil contracts can present
Page 6, ©2016 Advisor Perspectives, Inc. All rights reserved.
compelling opportunities for active management. One such opportunity arose following the start of the
U.S. shale revolution. Before 2011, the price relationship between U.S. crude oil (WTI) and globally
traded Brent crude oil was more stable. But starting in 2011, WTI began trading at a notable discount
to Brent. This resulted from the massive flow of U.S. crude oil to a delivery point in Cushing,
Oklahoma. However, there was not enough pipeline capacity to get WTI from Cushing to Gulf Coast
refineries, leading to elevated Cushing inventories and depressed WTI prices relative to Brent.
Understanding the drivers of this price dislocation and evaluating the potential catalysts for a price
reconnection created an opportunity to express a relative value view between the two variants of crude
oil. Research into energy transportation would have brought to light infrastructure developments to
move WTI from the middle of the country to the Gulf Coast, and knowing the timing of the projects’
completion would have added another important layer to formalizing a long WTI versus short Brent
trade.
Figure 4 highlights outgoing pipeline capacity from Cushing to the Gulf Coast and plots the price
differential between WTI and Brent crude. Pipeline capacity from Cushing, in fact, grew when the
Seaway pipeline reversed to flow to the Gulf Coast in June 2012 and expanded when the Seaway
project was completed in the first quarter of 2013. The completion of additional pipeline projects in the
second quarter of 2013 effectively finalized the convergence of WTI and Brent.
Portfolio construction
Trading March versus April natural gas or WTI versus Brent crude are just two examples of active
positioning within the commodity allocation that may help achieve returns above a passive commodity
index. But, in addition to conducting thorough bottom-up research at the individual commodity level to
generate views and active trade ideas, it is equally important to have a broad opportunity set and a
robust approach to portfolio construction.
First, it may prove beneficial to look across all commodity sectors that are represented in the
commodity index — e.g., petroleum, natural gas, agriculture and metals — to source ideas for active
trades. Doing so achieves the flexibility to shift active portfolio risk to those sectors that offer the most
Page 7, ©2016 Advisor Perspectives, Inc. All rights reserved.
compelling opportunities and helps avoid being forced into trades with suboptimal risk/return profiles.
Furthermore, we believe it is prudent to construct a diversified portfolio of active views with
uncorrelated investment themes so no single trade can dominate the risk profile. By ensuring that the
portfolio does not have concentrated risk exposure, a negative move in any one trade should not result
in a severe shock to the overall portfolio, because it is likely to be offset by returns from other active
views. As such, this approach is designed to offer a more consistent pattern of excess returns over
time.
Summary: Why commodities can fuel investment portfolios
Commodities have a place in many investors’ portfolios. Despite the most recent performance
challenges of the asset class, commodities continue to offer potential inflation protection, portfolio
diversification and enhanced longer-term returns.
Commodities also may offer – possibly more so than most asset classes – significant opportunities to
add value through active management. The economic foundation for these opportunities is provided by:
Rules-based commodity indexes and passive investors
A significant share of non-financial participants, i.e., hedgers, seeking to transfer price risk and
willing to pay a premium for that economic benefit
Bottom-up fundamental analysis to uncover mispricings due to supply/demand imbalances
In managing commodities, implementation considerations are paramount. Commodities always have
been a volatile asset class and active positions in commodities should be held in a risk-controlled
manner. This requires significant risk management expertise and investment in state-of-the-art risk
management systems. In other words, evaluation of risk management capabilities should be at the
forefront of due diligence on active commodity investment managers.
.....................................
Mr. Whitton is an executive vice president and real return product manager in the Newport Beach
office. He previously spent five years in Singapore as a director and head of PIMCO Asia Private
Limited, overseeing all aspects of the client servicing and business development efforts in Southeast
Asia. Mr. Whitton joined the firm as an account manager and a credit product specialist in Newport
Beach before relocating to Singapore in 2006. Prior to joining PIMCO in 2002, he was with Merrill
Lynch and Deloitte Consulting. He has 14 years of investment experience and holds an MBA from the
MIT Sloan School of Management and undergraduate degrees from California Polytechnic State
University, San Luis Obispo.
Mr. Thuerbach is a vice president and real return product manager in the Newport Beach office. Prior
to joining PIMCO in 2012, he was a relationship manager at Bankhaus Metzler in Germany.
Previously, he worked for the commingled funds group at Wellington Management Company in Boston
and London. He has nine years of investment experience and holds an MBA from The Wharton School
Page 8, ©2016 Advisor Perspectives, Inc. All rights reserved.
of the University of Pennsylvania, where he was a Palmer Scholar. He received undergraduate degrees
in international business from Northeastern University, Boston and ESB Reutlingen, Germany.
Ms. Botting is a senior product associate in the Newport Beach office, focusing on PIMCO’s real return
strategies, including commodities and inflation-linked bonds. Prior to joining the product management
group, she worked in PIMCO’s legal and compliance department. She joined the firm in 2006. She has
nine years of investment experience and holds an undergraduate degree in economics from the
University of California, Berkeley and is currently pursuing an MBA at the Anderson School of
Management at the University of California, Los Angeles.
The authors would like to thank Shawn Coffman for his contribution to this article.
DISCLOSURES
Past performance is not a guarantee or a reliable indicator of future results. All investments
contain risk and may lose value. Commodities contain heightened risk, including market, political,
regulatory and natural conditions, and may not be suitable for all investors.Derivatives and
commodity-linked derivatives may involve certain costs and risks, such as liquidity, interest rate,
market, credit, management and the risk that a position could not be closed when most advantageous.
Commodity-linked derivative instruments may involve additional costs and risks such as changes in
commodity index volatility or factors affecting a particular industry or commodity, such as drought,
floods, weather, livestock disease, embargoes, tariffs and international economic, political and
regulatory developments. Investing in derivatives could lose more than the amount invested.
Diversification does not ensure against loss. Management risk is the risk that the investment
techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain
policies or developments may affect the investment techniques available to PIMCO in connection with
managing the strategy. There is no guarantee that these investment strategies will work under all
market conditions or are suitable for all investors and each investor should evaluate their ability to
invest long-term, especially during periods of downturn in the market. Investors should consult their
investment professional prior to making an investment decision.
Figures are provided for illustrative purposes and are not indicative of the past or future performance of
any PIMCO product. Correlation is a statistical measure of how two securities move in relation to each
other. It is not possible to invest directly in an unmanaged index.
No representation is being made that any account, product, or strategy will or is likely to achieve profits,
losses, or results similar to those shown. Hypothetical or simulated performance results have several
inherent limitations. Unlike an actual performance record, simulated results do not represent actual
performance and are generally prepared with the benefit of hindsight. There are frequently sharp
differences between simulated performance results and the actual results subsequently achieved by
any particular account, product or strategy. In addition, since trades have not actually been executed,
simulated results cannot account for the impact of certain market risks such as lack of liquidity. There
are numerous other factors related to the markets in general or the implementation of any specific
investment strategy, which cannot be fully accounted for in the preparation of simulated results and all
Page 9, ©2016 Advisor Perspectives, Inc. All rights reserved.
of which can adversely affect actual results.
This material contains the opinions of the author but not necessarily those of PIMCO and such
opinions are subject to change without notice. This material has been distributed for informational
purposes only and should not be considered as investment advice or a recommendation of any
particular security, strategy or investment product. Information contained herein has been obtained
from sources believed to be reliable, but not guaranteed.
PIMCO provides services only to qualified institutions and investors. This is not an offer to any person
in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company
LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States
Securities and Exchange Commission. | PIMCO Investments LLC, U.S. distributor, 1633 Broadway,
New York, NY, 10019 is a company of PIMCO. | PIMCO Europe Ltd (Company No. 2604517), PIMCO
Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company
No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North
Colonnade, Canary Wharf, London E14 5HS) in the U.K. The Amsterdam and Italy branches are
additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian
Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only
to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available
to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH
(Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the
German Federal Financial Supervisory Authority (BaFin) (Marie-Curie-Str. 24-28, 60439 Frankfurt am
Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and
products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in
Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual
investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH(registered in
Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland,
Tel: + 41 44 512 49 10. The services and products provided by PIMCO Switzerland GmbH are not
available to individual investors, who should not rely on this communication but contact their financial
adviser. | PIMCO Asia Pte Ltd (501 Orchard Road #09-03, Wheelock Place, Singapore 238880,
Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a
capital markets services licence and an exempt financial adviser. The asset management services and
investment products are not available to persons where provision of such services and products is
unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No.
8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types
1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management
services and investment products are not available to persons where provision of such services and
products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO
Australia) offers products and services to both wholesale and retail clients as defined in the
Corporations Act 2001 (limited to general financial product advice in the case of retail clients). This
communication is provided for general information only without taking into account the objectives,
financial situation or needs of any particular investors. | PIMCO Japan Ltd (Toranomon Towers Office
18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business
Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382.
PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts
Page 10, ©2016 Advisor Perspectives, Inc. All rights reserved.
Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are
offered only to persons within its respective jurisdiction, and are not available to persons where
provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon
prices of securities and values of derivative transactions in the portfolio, market conditions, interest
rates and credit risk, among others. Investments in foreign currency denominated assets will be
affected by foreign exchange rates. There is no guarantee that the principal amount of the investment
will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits
and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of
each type of fee and expense and their total amounts will vary depending on the investment strategy,
the status of investment performance, period of management and outstanding balance of assets and
thus such fees and expenses cannot be set forth herein.|PIMCO Canada Corp. (199 Bay Street, Suite
2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may
only be available in certain provinces or territories of Canada and only through dealers authorized for
that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1o andar, Rio
de Janeiro – RJ Brasil 22210-906. | No part of this publication may be reproduced in any form, or
referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL
INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of
America L.P. and Pacific Investment Management Company LLC, respectively, in the United States
and throughout the world.
© 2015, PIMCO.
Page 11, ©2016 Advisor Perspectives, Inc. All rights reserved.