January 14, 2018
For many investors, the goal of investing in commodity funds is to achieve portfolio diversification, protect against unexpected inflation, and potential return enhancement. Broad based commodity ETFs and mutual funds are especially popular vehicles to gain commodity exposure due to their ease of investment, cost efficiency and liquidity. However, many of these funds are holding assets that may not be correlated to the goals described above. When it comes to commodity mutual funds, if you aren't sure, you better read the fine print.
Last Wednesday Bloomberg reported that unnamed Chinese officials threatened to slow or halt altogether the purchase of US Treasury securities. While this is not exactly "new" news, it did remind bond holders of the power of the Chinese purchases and what could happen to bond prices if the Chinese stopped buying, or even worse started selling US bonds. Combine that with an equity market rally that is by any sense of measured "long in the tooth" and it should give pause to re-exam ones portfolio holdings. While commodity funds don't come first to mind when thinking about stock or bond risk, we suggest you might want to take a closer look at your fund holdings. A short primer on commodity funds may help explain why.
Source: S&P Dow Jones, Federal Reserve Bank of NY
Gaining commodity exposure through the purchase of physical assets is generally not practical , so funds gain commodity exposure through various other commodity interests. These can be swap contracts, forward contracts, etc. but most obtain exposure through exchange traded futures contracts. Exchange traded futures while not a direct investment into the physical commodity do provide a highly correlated return profile to the physical commodity. Returns in commodity futures can be broken down into two parts. The yield achieved from the absolute price exposure is termed "excess return". The second is a side benefit in the form of a "collateral yield".
Unlike investing in traditional assets, when you purchase exchange futures contracts you are not required to pay the full nominal price of the asset. Instead, you post a good faith collateral deposit generally referred to as a performance bond. The amount that you are required to post is determined by the exchange clearing corporation and is referred to as margin. As of this post, the typical initial margin for a commodity future is roughly 3-5% of the total contract value. The exchange clearing firm excepts various forms of collateral including US dollars, US Treasuries, some asset backed and agency bonds, as well as select foreign currencies and sovereign debts. Swaps and forward contracts have their own rules, but again, do not require the purchaser to put up the entire investment amount.
So what does a fund manager do with the other 95% of cash held outside of required margin?
Here is where the lines between a commodity fund and a "hybrid" fund can become blurred. What I would call "pure" funds typically invest access capital in cash or cash equivalent instruments like Treasury Bills with maturities of 1 year or less. These are considered "risk free" and because of their short maturities, carry the least amount of interest rate risk. They also typically return the lowest yields and since the credit crisis that began in 2007, yields have been extraordinarily low. This created an environment for investment managers to "reach for yield". In the case of some commodity funds, reaching for yield has meant investing further out the treasury maturity curve or purchasing commodity equity interests.
To be fair, this may have been part of the original stated investment strategy, but if not, managers may be developing what we call "style drift".
In the case of increasing bond maturity, yes, most of these are still US backed government securities with effectively little to no risk of principal loss. However, that only holds true if you hold them to maturity. By extending out the maturity curve (buying longer dated bonds) the portfolio increases its duration or the sensitivity of the bonds price to changes in interest rates. A sharp rise in interest rates will push bonds with higher duration down more in price than equivalent credit/coupon bonds with lower duration. As a general rule, a bonds duration (in years) equates to approximately how much that bond will move in price for a 1.00% change in yield. The price of a bond with a four year duration will drop roughly 4% with a 1% change in yield.
In other words, if rates rise dramatically, the bond portion of the commodity portfolio will loose value based on its duration and if sold could incur principal losses. Essentially, commodity funds that invest their excess capital in "non-cash" securities with a net maturity in excess of 1 year are at greater risk of under-performing in periods of rapidly rising interest rates. Of course the opposite can also be said. For the last several years, extending duration (intended or not) has been an effective strategy earning higher collateral yields and hence total returns than those funds holding cash. However, given the current multi-decade low in bond yields, recent actions by the Fed to normalize rates, and a US economy that appears to be expanding, lower yields would seem less likely.
Below, we focus on broad based commodity mutual funds with assets under management (AUM) above $10 million, as categorized by Morningstar. The graph below shows mutual funds that currently hold collateral in the form of bonds outside of the 1 year maturity. The chart shows the percentage of bond holdings broken down by maturity range. It is important to note however, that some funds like the PIMCO Commodity Real Return Strategy fund (PCRAX) and PIMCO CommoditiesPlus Strategy fund (PCLAX) hold both long and short bond positions, as well as TIPs or Treasury Inflation Protected securities. Selling bonds (or bond futures) has the effect of shortening duration. Likewise, TIPs offer inflation protections above that of standard bonds, but are still subject to duration price effects.
Source: Morningstar (As of most recent data available)
Chart two below shows the percentage long and short of the same funds holding bonds with maturities greater than 1 year. Unfortunately, it is impossible to determine the duration of the individual funds given the data available, but clearly some investigation into your funds holdings may be appropriate. To further complicate the picture, some funds also include US and non-US stocks into their portfolio introducing an equity risk component into the fund.
Source: Morningstar (As of most recent data available)
Here the data is clearer as none of the commodity funds we researched sell short equities. The chart below lists commodity funds that hold long equity positions. We estimate that a majority of the stock purchases are equities of commodity producing firms. This is the stated strategy of the BlackRock Commodity Strategies Portfolio (BICSX) and not surprisingly, it was one of the best three year performers given the equity rally. This is also a perfectly sensible strategy, but investors should be aware that along with introducing equity exposure, this increases the funds equity correlation and decreases its effectiveness as a diversifier.
Source: Morningstar (As of most recent data available)
Of course there are also a hand full of funds that hold bonds (>1yr) and stocks. The most notable of those being the Deutsche Enhanced Commodity Strategy Fund (SKNRX). As of this report, this fund has nearly $3 billion in AUM, holds multi sector bonds across every maturity range as well as stocks. Somewhat surprisingly, this fund under-performed many of its more traditional commodity peers for the past three years.
In summary, there is nothing wrong with holding longer term bonds or commodity based stocks in a commodity fund and they can produce benefits. However, investors should also be aware that including these assets can add risk not generally associated with commodities and this risk may work against the original intention of the investor.
Some of these funds employ stocks/bonds to such a degree that one has to question if they are commodity funds at all or more simply hybrid portfolios?
With a mind toward investment goals, we highly recommend taking a close look at what your commodity fund is holding in the form of both excess collateral and equity exposure. Most investors portfolios are already well invested in both of these traditional sectors and the addition of funds that add these assets are likely unnecessary at best and unwelcome at worst. There are however many "pure" commodity funds available (see table below) that neither invest excess collateral in bonds or invest in equity securities. Under the the current environment, if diversification, inflation protection and "excess commodity yield" is what you're looking for in a fund, look at the more "pure" commodity versions.
Commodity Mutual Funds (AUM > $10M):
|BICSX||BlackRock Commodity Strategies Portfolio||No||Yes||253|
|BRCNX||Invesco Balanced-Risk Commodity Strategy Fund||No||No||915|
|CCRSX||Credit Suisse Trust Commodity Return Strategy||Yes||No||413|
|CCSAX||Columbia Commodity Strategy Fund||No||No||520|
|CFHAX||Catalyst Hedged Commodity Strategy Fund||Yes||Yes||99|
|CMCAX||VanEck CM Commodity Index Fund||No||No||390|
|CRCAX||Credit Suisse Commodity Access Strategy Fund||Yes||No||36|
|CRSAX||Credit Suisse Commodity Return Strategy Fund||Yes||No||3393|
|CSAFX||JPMorgan Commodities Strategy Fund||No||No||186|
|DBCMX||DoubleLine Strategic Commodity Fund||No||No||115|
|DCMSX||DFA Commodity Strategy Portfolio||Yes||No||1782|
|DXCTX||Direxion Indexed Commodity Strategy Fund||No||No||20|
|EACSX||Eaton Vance Commodity Strategy Fund||Yes||Yes||22|
|EIPCX||Parametric Commodity Strategy Fund||No||No||253|
|FCSSX||Fidelity Series Commodity Strategy Fund||No||No||4098|
|FLSQX||Franklin Pelagos Commodites Strategy Fund||Yes||Yes||133|
|FYHTX||Fidelity Commodity Strategy Fund||No||No||825|
|GSCAX||Goldman Sachs Commodity Strategy Fund||Yes||No||387|
|HCMRX||Harbor Commodity Real return Strategy Fund||Yes||No||38|
|JCRCX||ALPS Core Commodity Management Complete Commodities Strategy Fund||Yes||Yes||569|
|MCSAX||MFS Commodity Strategy Fund||Yes||No||594|
|NGVAX||Nuveen gresham Diversified Commodity Strategy Fund||No||No||103|
|NRBAX||Neuberger Berman Risk Balanced Commodity Strategy Fund||Yes||No||133|
|PCLAX||PIMCO Commodity PLUS Strategy Fund||Yes||No||3161|
|PCRAX||PIMCO Commodity Real return Strategy Fund||Yes||No||6242|
|PCYAX||PCS Commodity Strategy Fund||No||No||35|
|PQCMX||Prudential Commodity Strategies Fund||No||No||16|
|QRCRX||AQR Risk-Balanced Commodities Strategy Fund||No||No||210|
|RCSAX||Russell Investments Commodity Strategy Fund||No||No||718|
|RYMEX||Rydex Commodities Fund||Yes||Yes||25|
|SKNRX||Deutsche Enhanced Commodity Strategy Fund||Yes||Yes||2931|
|SPCAX||SilverPepper Commodity Strategies Global Macro Fund||No||Yes||133|
|SUNAX||AIG Commodity Strategy Fund||Yes||No||40|
Shawn Bingham is a 25+ year veteran of the futures and options industry. He was the co-founder of Midwest Trading Partners LLC, a boutique managed futures business catering to HNW clients and fund of funds. Mr. Bingham has recently launched ABSR Research, LLC, a niche firm dedicated to providing commodity based research and consulting services to the investment management community, producers, transformation agents, end users, and speculators.