PIMCO: "Commodity Investing: A New Take on Equities Versus Futures"

Roll yield! Sharpe ratios!! Risk!!!

From Pacific Investment Management Co:

A combination of commodity futures and broad stocks seems to provide better return per unit of risk than natural resource equities.

Summary

• We examined the assumption that natural resource equities perform better because they avoid the roll yield common in commodity futures.
• A replicating portfolio modestly outperformed broad natural resource equities in absolute terms, but generated significantly higher Sharpe ratios.
• Investors in natural resource equities take more risks than they are compensated for. 

After the challenges in commodity markets in recent years, many investors are looking to bring their exposures back in line with their longer-term allocation targets. As a result, they are revisiting the issue of whether it is better to invest in commodities directly through commodity futures or indirectly through exposure to natural resource equities (NREs).

An argument is often made that investing in NREs results in better performance, in large part because investors avoid the potential headwinds of roll yield. Commodity futures investors are exposed to roll yield when they sell a contract before delivery and “roll into” a more distant contract. Roll yield can be positive (with downward sloping futures curves) or negative (with upward sloping futures curves). While it’s true that NREs are not directly impacted by roll yield, they carry their own risks, namely equity beta and higher volatility, for which investors should be compensated.

To investigate further, we created a framework for comparing the performance of NREs and commodity futures on an apples-to-apples basis. We found that two main factors contribute to NRE portfolio returns: a broad equity market factor and a commodity factor. Assuming that the market is efficient, we reasoned that an NRE portfolio would neither underperform nor outperform a portfolio that matches the same risk factors by taking exposure to a mix of broad equities and commodity futures.

Our key findings include:

• NRE exposure can be replicated by partial investments in the broad stock market and in commodity futures.
  
  
• On average, an investment of $0.90 in the S&P 500 and $0.41 in commodity futures tracked a $1.00 investment in broad NREs with a high correlation of 0.8.
  
  
• Overall, the replicating portfolio modestly outperformed broad NREs in absolute terms, and because of its lower volatility, it also generated significantly higher Sharpe ratios.
  
  
• When extending the analysis to specific sectors (i.e., oil companies or mining companies), the replicating portfolios did not always outperform. For example, an oil industry equity portfolio was able to generate higher absolute (and comparable risk-adjusted) returns over time relative to a replicating investment in the S&P 500 and oil futures.
  
  
• The worst performing NRE sector relative to its replicating portfolio was gold.

The implications of these findings are very relevant for investors today: More often than not, it seems there is better return per unit of risk when investing in a combination of commodity futures and broad stocks than in natural resource equities.

Analyzing and comparing returns Our analysis focused on broad NREs as well as five individual NRE sectors (see Figure 1).

To construct a replicating portfolio for each NRE sector, we used regression models to find the combination of S&P 500 and commodity futures investment weights (also called betas) that most closely represented the returns posted by a basket of NREs. To capture changes in the relationship over time, a monthly rolling regression was estimated using a 10-year window. For each month, a replicating portfolio was then created with the corresponding betas in the S&P 500 and commodity futures as well as a cash component in case the two factor betas didn’t sum to 100% (they typically didn’t). For example, if the commodity beta was 0.4 and the equity beta was 0.8, then the allocation to cash would be ‒0.2 to bring the total exposure in percent market value terms to 100%. This approach essentially eliminated in-sample bias as the replicating portfolio was generated using past data only. (The appendix contains a comprehensive description of the methodology.)

Figure 2 illustrates the evolving nature of factor betas. For broad NREs, the S&P 500 beta ranged from about 0.6 to 1.1 while the commodity beta generally increased over time from a low beta of 0.2 to a recent beta of 0.6.

Figure 3 displays the average regression results for broad NREs and select NRE sectors over the fully available time periods.

In general, most NRE sectors showed a higher beta to equity markets than to their respective commodity markets. The exception was gold, which demonstrated a high commodity beta and the lowest beta to the equity market. All replicating portfolios outside of agriculture observed high R² and explanatory power. The appendix provides summary statistics on the regressions (Figure 9).

Real implications are risks and returns While it is academically informative to expose the underlying economics of NREs, namely the extent to which they are influenced by the equity risk premium and their underlying commodities, the real implications for investors are risk and return characteristics. Figure 4 offers summary returns and volatilities for each sector with the maximum time periods available....MORE