Investors have traditionally sought commodity exposure through index-based products or commodity related equities, both of which, unfortunately, are not without issues. Traditional commodity indexes tend to concentrate exposures - and therefore risks - among a handful of economically sensitive commodities which impairs the diversification benefit afforded to the portfolio, especially in relation to equities. Additionally, the traditional commodity indexes ignore important sources of returns available to non-index commodity investors. Commodity related equities provide imperfect exposure to commodities due to the idiosyncratic characteristics of individual companies. Additionally, commodity-related equities provide little in the way of diversification benefits, as they tend to behave in a similar fashion to non-commodity equities through the market cycle. Our process seeks to correct for these issues through gaining risk-balanced exposures to the different commodity complexes while focusing on capturing the various sources of returns available to active commodity investors.
Focus and Objectives
The strategy focuses on four key drivers of commodity returns: storage difficulty, rebalancing return, optimal roll yield and tactical allocation. As none of these sources of returns are available in the primary commodity indexes, the strategy is built without regard to benchmark considerations.
The portfolio is built utilizing a risk-premium capture strategy that seeks to generate returns by investing in the commodity markets using a risk-balanced investment process. The strategy is diversified across the commodity complex including, but not limited to, energy, agriculture, precious metals and industrial metals. The team selects the appropriate assets for the strategy, allocates them based on proprietary risk management and portfolio construction techniques and then applies an active positioning process to improve expected returns.
We employ a three step investment process:
The first step of the process translates the desired characteristics of the portfolio into three asset selection criteria. First, we use a correlation matrix to determine the marginal impact on diversification for each asset. The second set of criteria covers expected excess returns of risk premia for the selected markets. The third step relates to ensuring adequate liquidity, flexibility and transparency exists in the instruments and assets used to build the portfolio.
Rather than focus on asset weights in a portfolio which can leave investors heavily dependent on the performance of one asset class, or the occurrence of one particular economic environment, we begin by examining how each asset contributes to overall portfolio risk. We build the portfolio so that an equal amount of risk comes from each asset class which produces a portfolio that is better hedged against negative economic outcomes like high inflation or deflation while still retaining the ability to participate in constructive market environments.
The final step in the process is active positioning, or tactical allocation. Active positioning allows the risk weights to deviate from a strict risk-balanced structure based upon our evaluation of the assets along three factor concepts: valuation, the economic environment and price trends and reversals. Tactical overweights are applied to assets expected to outperform cash over the evaluation period and underweights are applied to assets expected to underperform cash. This process serves to adapt the portfolio to the prevailing economic environment.