Advantages and Disadvantages of Actively Managed Commodity Strategy

Oct 1, 2020 03:10 AM ET
Advantages and Disadvantages of Actively Managed Commodity Strategy

What is an Actively Managed Commodity Strategy?

An actively managed commodity strategy gives portfolio managers the power to select individual securities in such a way as to outperform a previously identified benchmark. The role of active commodity strategies can be considered as a satellite to an investor’s core exposure to commodities, which in turn are obtained from via commodity index investments. An investor obtains consistent exposure to the inherent returns of commodities through commodity indexes. 

In the case of an actively managed commodity hedge fund, no one can quite guarantee whether the manager will remain consistently long on commodities.  One of the core principles for risk management for most hedge funds is by neutralizing systematic risk through hedging. Always remember that an idealized hedge fund is not supposed to be delivering a consistent beta. It is rather supposed to deliver well-timed beta exposures in case of a global macro fund, or pure alpha exposures, in the case of a relative-value fund. 

An investor’s long-term asset allocation plan can be designed around the expectation that his commodity allocation provides adequate protection against an economic shock, such as an oil shock. However, in this case, the plan’s purpose could be compromised if it involves investing exclusively in an actively managed commodity program. For instance, before the Gulf War, an active commodity program might have excluded long positions in oil because the term structure of that futures market indicated a surplus. If an investor’s commodity exposure is solely with such a program, the investor can miss out on having an oil dislocation hedge. 

Advantages Of An Actively Managed Commodity Strategy

Once an investor obtains his core commodity exposure through a commodity index investment, the next step is to add active commodity managers for further value addition.  This is analogous to the changing nature of equity management, whereby passive and active management is being unbundled. This is why a number of investors are now getting their core equity exposure through equity index funds, futures, and ETFs after which they invest in long or short equity hedge funds. 

Inflation Protection

 The prices of commodities tend to increase if inflation rates are high. This makes commodities one of the few assets that perform well in inflation. 

Diversification and Mitigation of Downside Risk

Actively managed strategies offer a diversified allocation that helps in reducing downside market participation. It also seeks to select managers who provide better risk-adjusted returns than their underlying benchmark over the span of a full market circle. These types of strategies also tend to change a portion of the traditional equity allocation to investments specifically designed to reduce equity risk. These include both long/short as well as high yield equity strategies. 

Disadvantages of an Actively Managed Commodity Strategy

Scalability

One of the main limitations of an actively managed commodity strategy is scalability. This is due to 2 sources. The first one is due to hedge fund strategies being capacity constrained by definition, which exploits inefficiencies. These inefficiencies are supplied by other investors. The plausible maximum size of the hedge fund industry is 6% that of institutional and high net worth assets.

Limit on Size

Unlike investors in the securities markets, traders of futures contracts may not exceed the speculative position limits or spec limits set for particular markets. Spec limits impose a limit on the size of the net position that speculators may hold. Their holdings may span overnight in a single contract month and in all contract months of a particular commodity. In many instances, this limit is even more restrictive in the spot month.  One of the reasons why spec limits exist is to prevent a trader from amassing a large position that they can use to manipulate prices in the future. 

Why Is There A Shift from Active To Passive Investing?

Over the past few decades, there has been a considerable shift from active to passive when it comes to investment strategies. There are a number of factors responsible for this. For instance, the development of the efficient markets hypothesis in the 1950s and 60s, questioned the very concept of active selection of securities when it comes to beating the market. In the 1970s when the first stock index funds appeared, it was considered as a practical option for most retail investors. 

Another reason is the relatively lower cost associated with passive investing as well as the evidence of active managers underperforming. The greater regulatory focus on investment product fees may have encouraged the financial industry to offer passive products to individual investors at low costs. 

This shift from active to passive management has lit up debates about its effects on asset prices, volatility, price discovery, market liquidity, industry concentration, and a number of other factors. The growth of passive investing is thus considered a part of a much larger shift to systematic investment strategies, which includes beta and qualitative investment strategies. This can have significant implications for asset prices, market microstructure, and risk management. 

How The Active To Passive Shift Affects Financial Stability Risks

Type Of Risk

Description

Impact Of Financial Stability Risks

  • Asset management industry concentration

The shift to passive increases concentration for passive asset managers

Increases

  • Investing Strategies that amplify volatility

Inverse and leveraged funds require high-frequency momentum trades, even when there is no flow

Increases

  • Liquidity transformation and redemptions

Regardless of the portfolio liquidity, funds redeem daily in cash. Investor flows respond in a pro-cyclical manner to performance. 

Reduces

  • Changes in the valuation of assets and volatility

Assets which are added to indices experience changes in liquidity and returns, which includes greater co-movement

It is uncertain

 

Final Thoughts

The successful implementation of an actively managed commodities strategy requires extra care in risk management, as well as an exceptional discipline while implementing, which falls on the shoulder of the active manager. One should be careful when recommending an actively managed commodity program given how beneficial indexed investments in commodities are. That being said, active managers with skills can potentially provide returns in excess of an investor’s core indexed commodity exposure. 


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