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Eric Onstad
Sunday, November 11, 2012
From Print Edition
 
 

 

LONDON: Banks are struggling to devise new commodity index products as once-fat returns fizzle out in a business worth $140 billion, putting pressure on bank commodity businesses already hit by tighter regulations.

 

Up until this year, the banks had managed to come up with fresh ways of perking up returns for the index products and retain uneasy investors, who still see commodities as a bet against inflation.

 

As a flood of money into the sector has diluted returns, however, now even many of the complex products spiced up with computer algorithms are underperforming, and some investors are questioning their commitments to the sector.

 

An erosion of the index investment business would remove an important remaining money-spinner for banks in commodities.

 

Their total turnover in the sector has tumbled by half to $7 billion, partly due to a regulatory crackdown on proprietary trading in which banks take positions on their own behalf rather than for clients.

 

Industry figures acknowledge the difficulty in finding ways to recapture the high profits enjoyed during the early years of a commodities boom fuelled by Chinese hunger for raw materials.

 

“The asset class is getting more crowded. It’s harder and harder to get the risk premium that originally attracted investors into this space,” Dan Raab, head of commodity investor marketing and structuring at UBS Securities, told a recent commodities conference before unveiling new products.

 

UBS owns one of the two main indexes that attract the bulk of investment into the commodity index sector - the Dow Jones UBS index. The other is the S&P Goldman Sachs Commodity Index (GSCI).

 

Investors, who piled into bank index products from about 2000, seeking to diversify portfolios and capture growth in emerging markets, were initially rewarded with juicy returns.

 

Standard indexes shot up during the early years of the boom, fuelled by China’s demand for commodities. The DJ-UBS total return index more than doubled from 2000 to 2007.

 

But the gains began to diminish due to the combined impact of the global financial crisis and a deluge of investment cash into a relatively thin commodity sector, forcing banks to come up with ever more complex products.

 

Since the start of 2008, the DJ-UBS index has lost a fifth. It is virtually flat this year compared with a 15 percent rise in the S&P 500 equity index.

 

More worrying for the banks, many of the enhanced commodity products are also underperforming.

 

Barclays said last week both its forward curve strategy and more sophisticated ComBATS 6 index product, which takes long and short positions in 10 commodities, were in the red by 1.22 percent and 2.3 percent so far this year.

 

Both had generated positive returns after 2007, including 5.2 percent last year and over 12 percent in 2008 for ComBATS 6.

 

Some other indexes are still squeezing out a premium, such as the S&P GSCI Dynamic Roll, which remains ahead of the plain index by 3.5 percentage points this year.

 

Flows into the huge commodity index sector have been eroding, falling by $4.6 billion last year after jumping by $33 billion in 2010.

 

This year through September, another $2.8 billion has left the sector, according to data from Barclays, which tracks the sector.

 

Total assets in index products, which also include the impact of commodity prices, have been relatively flat at $142 billion in September, compared with $137 billion at the end of last year.

 

Many investors have stuck with the sector, which makes up about a third of total commodity assets under management, due to persistent worries about inflation and efforts to diversify.

 

But instead of reaping a premium, commodity investors may now be paying for insurance against inflation, said Kelvin Milgate, head of multi-commodity investor products at the commodity trading division of Koch Industries.

 

“We believe investors in some markets may be paying some kind of risk premium to fulfill the diversification and inflation-protecting benefits from having commodities in their portfolio.”

 

Some industry figures say the premium investors get from commodity futures boils down to their taking on risk by financing hedging activity by producers and consumers, but a flood of investment has spread that premium too thin.

 

Michael Azlen, executive chairman of Frontier Investment Management in London, said he was reviewing his firm’s 10 percent allocation to commodities, wondering whether the structural risk premium has evaporated as commodities more closely track other financial markets.

 

“For the commodities space, it’s a very difficult time right now for anyone who looks at the big picture and who academically, empirically assesses whether this has a place in my portfolio,” he said.

 

Frontier, which specialises in multi-asset funds, has $600 million under management.

 

A key area that has deflated returns is the shape of futures curves.

 

Commodity index returns were boosted by “roll yield” coming from markets where spot prices were higher than forward ones, allowing extra gains when expiring futures are moved ahead on the curve to cheaper contracts.

 

But as more investors crowded onto the front end of curves, those returns dwindled, prompting banks to come up with products that either place investors forward on the curve or use complex algorithms to identify the most lucrative spots on the curve.

 

“The ease of generating alpha from the term structure or using momentum that worked really well up until about 18 months ago. Now there’s so much money chasing these opportunities,” Tyler Stevens of the US-based Commonfund said.

 

His firm manages $24 billion of assets, of which 2 percent is invested in commodities and 9 percent in natural resources.

 

Alpha measures the risk-adjusted return of an investment or the return in excess of a benchmark index.

 

Some investors got burned in July after agricultural index products that invest on forward contracts lost money when the front end of the curve spiked due to a severe drought in the United States.