Commodity futures’ hot streak could stall

Institutional investors plunging into commodity futures may not get the returns they're expecting.

About two-thirds of nearly $70 billion in passively managed commodity futures investments tracked the Goldman Sachs Commodity index as of Sept. 30, according to Goldman Sachs & Co., New York. David Burkart, senior portfolio manager and strategist at Barclays Global Investors, San Francisco, said institutional investors poured $35 billion into commodity futures in 2005, and he expects another $35 billion to flow into the asset class next year.

For the past 45 years, investors in commodity futures have been rewarded handsomely. The asset class has generated equity-like returns with slightly less than stock-market volatility, according to a widely read paper by Gary Gorton, a professor at the University of Pennsylvania's Wharton School, Philadelphia, and K. Geert Rouwenhorst, a professor at Yale University's School of Management, New Haven, Conn.

What's more, commodity futures returns tend to go up in value when stock and bond markets go down, making them important diversifiers, the academics found. That's especially true during periods of rising inflation, they wrote.

Major pension funds, including Dutch giants ABP and PGGM, Ontario Teachers' Pension Plan, Pennsylvania State Employees' Retirement System, Nestle USA Inc. and others, have made allocations to the asset class. The $200.2 billion California Public Employees' Retirement System, Sacramento, plans to consider making a pilot investment in commodity futures this spring.

Recent returns have been strong as stock-market returns have lagged. For the three-year period ended Nov. 30, the Goldman Sachs Commodity index returned an annualized 23.3%. In the first 11 months of 2005, the index returned 22%.

But some experts question whether those rosy numbers will continue. One concern is the sheer volume of money that's flooding into the asset class. As institutional investors pour billions of dollars into commodity futures, the risk premium is bound to shrink. Some say the premium already is declining.

A second argument is far more arcane, but at the heart of a major dispute between researchers.

Messrs. Gorton and Rouwenhorst argue that historic returns from commodity futures stem mostly from "normal backwardation" — a term coined by John Maynard Keynes — meaning investors, on average, are rewarded for providing insurance to protect commodity producers from dips in prices.

Messrs. Gorton and Rouwenhorst's paper supports Mr. Keynes' hypothesis: Commodity futures generated an annual risk premium of 5.23 percentage points between July 1, 1959, and Dec. 31, 2004, based on an equally weighted database they constructed. (In comparison, stocks and bonds generated average risk premiums of 5.65 and 2.22 percentage points, respectively, during the 45%BD;-year span.)

That insurance premium largely stems from rolling futures contracts. Because commodity futures are often priced lower than the spot price, investors profit as the prices converge. In contrast, changes in spot prices are not a source of return for investors in futures, the academics' paper says, though other researchers disagree.

"There's a question as to why there should be a return from rolling commodity futures," said Ben Inker, director of asset allocation at Grantham, Mayo, van Otterloo & Co. LLC, Boston. He said no similar return exists for rolling stock or bond futures.

"And that gives institutional investors fits, because they've got an asset class that has a nice diversification benefit, and they don't know if it has any return," Mr. Inker said. If commodity futures retain stock-market-level volatility but offer a cash return, investors "might as well just own the cash," he said.

An alternative analysis is offered by Claude Erb, managing director at Trust Company of the West, Los Angeles, and Campbell Harvey, a professor at Duke University's Fuqua School of Business, Durham, N.C. They said commodity futures do provide a return over the risk-free rate, but that Messrs. Gorton and Rouwenhorst have misinterpreted the source of the return.

Messrs. Erb and Harvey argue the long-term risk premium for commodity futures, which they estimate at three percentage points a year, comes from monthly rebalancing of the portfolio, based on an equal-weighted GSCI. That means the average return from a portfolio that is not rebalanced, such as the GSCI, is zero. (In contrast, the Dow Jones-AIG Commodity index is rebalanced annually, and a recently revamped Reuters-CRB Futures Price index is rebalanced monthly.)

"Think about this as a turning-water-into-wine experience," Mr. Erb said in an interview. ""You have a bunch of assets with a long-term expected return of zero, and volatility of 30% to 40%. If you mix and match them, you can have a risk premium of, say, 4%," he said.

Mr. Erb said the notion of normal backwardation doesn't work for many commodities. While energy — which comprises about three-quarters of the GSCI — displays normal backwardation about 60% of the time, the futures price for other commodities, such as gold, is usually higher than the spot price. In those situations, the commodities are said to be "contango."

The risk premium "has nothing to do with backwardation," Mr. Erb said. Rather, it's "100% from rebalancing." The Erb-Harvey paper suggested that a couple of simple active commodities strategies such as simple rebalancing or long-short portfolios can generate positive returns. (TCW is developing several active commodities strategies, but Mr. Harvey has no involvement with the manager.)

In an interview, Messrs. Rouwenhorst and Gorton rebutted the contentions of Messrs. Erb and Harvey.

"We don't disagree that it's possible to outperform an index by cleverly choosing commodities. What we disagree with is what is the risk premium for commodities," Mr. Rouwenhorst said.

The academics said a buy-and-hold strategy produced a 6% risk premium, marginally outperforming a portfolio that was rebalanced monthly. The bottom line: rebalancing did not provide any risk premium.

One expert said commodity futures returns rely heavily on cyclical factors but do offer a positive risk premium.

Heather Shemilt, global head of Goldman Sachs' commodity index business in New York, said commodity futures prices rise when the economy is strong. In the first part of the cycle, increasing demand drives up commodity prices. In the second stage, low inventories result in backwardation, she explained.

Backwardation only occurs, however, where commodities are difficult to store and they can't be borrowed — such as oil.