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Commodities May Be Lackluster, But Alpha Is Still Achievable – Seeking Alpha

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This article is written by Kimberly Rios, CFA, CMT, and portfolio manager of the Catalyst Hedged Commodity Strategy Fund (CFHAX).

Commodities have been out of favor over the past few years. Most commodity funds have struggled to achieve even a positive return. For the many investors exposed to this asset class, selecting the right exposure can feel like choosing the lesser of two evils. Oil may finally be back on the rise, but corn is on the decline. These sluggish and inconsistent returns can not only prove counterproductive to a portfolio’s objective, but counteract the gains from other asset exposure.

The key to achieving alpha in commodities is not to reallocate exposure away from the asset altogether. Rather, commodities remain an important portfolio diversifier because of the uncorrelated returns they can offer. But capitalizing on this asset class is different than equities; the variations have to be taken into consideration when investing. The ability to generate positive returns can lie in the strategy and execution, not necessarily picking the “right” commodity or forecasting the next directional trend. Actively managed commodity funds, for example, have been able to achieve positive returns YTD in this less than ideal landscape of relatively low volatility and range-bound trading.

Strategy matters simply because commodities are unique in their requirement for operational costs. Take for example storage costs. If you want to own oil or corn, you’ll need to store it somewhere, and that costs money. Additionally, delivery and insurance costs come into play. The price tag varies by commodity, but the cost is applicable to the overall asset class, making direct investments quite different than a traditional equities or fixed income position.

These costs are also reflected in futures and options trades, which tend to be the favored investment instrument of most commodity funds. The actuality of contango and backwardation, also known as roll yield, are correlated to these operational costs. When a commodity market is in contango, a future contract for the month of October will be less than the contract for December, because the December contract must factor in the cost of storage and insurance for two additional months. When a long-only or commodity tracking fund needs to extend its futures position, it must pay a premium to extend these contract dates.

Consequently, long-only and solely systematic commodities strategies can have ongoing headwinds. There are several reasons for this. First, Exchange Traded Products (ETP’s) and funds that attempt to replicate an index can have difficulty tracking the spot price of a commodity over time. These derivate tracking issues can reduce returns, as different returns are experienced when investing in commodity futures (compared to what the spot prices indicate).

Second is predictability. A large fund can have monthly futures rolls, which can be front-run by professional traders who know when the rolls will take place. “Pre-rolling” is trading the next month ahead of the expected large programmed rolls, which is a common feature of passively managed funds. Funds exposed to this are at risk of potentially having to pay more for new positions, which in turn diminishes returns.

Commodities have seasons with prices and volatilities that oscillate up and down rather than rise over long periods of time, like equities. These asset prices are driven by supply and demand. A long position in agricultural futures during the winter months may be less optimal due to the minimal fluctuation of price and volatility during that time period. Unfortunately, this type of investing in commodities is common. In the case of the long agriculture position, a lack of a significant price movement in conjunction with a futures curve in contango, one is likely to lose money.

Adjusting trades as the markets change can prove beneficial. Rather than trying to predict where the markets will be and when, using a strategy that reacts to changes in price and volatility can be successful. This flexibility may be better suited for the types of movements seen in commodities. An additional consideration is active trades of options on commodity futures. Options, when combined in the correct combination and strategy, can potentially limit risk compared to just buying or selling a futures contract. Strategies that rely on this type of commodities investment are available to investors in the mutual fund format, not only just at hedge funds or other private vehicles.

As commodities continue to track an unpredictable path, an actively managed strategy can provide steadiness and flexibility against downturns. One way to achieve this is by actively adjusting holdings, and factoring in the distinctive aspects that make commodities a unique asset class. With costs like storage and insurance an important component to any commodities exposure, investors that rely on strategies that incorporate these operational considerations have the potential to successfully achieve alpha.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: **The fund Kimberly manages, CFHAX, trades long and short call and put options on physical commodity futures contracts in agricultural products, energy and metals.