Don’t dismiss short side on commodities

(January 19, 2005) Investors who think they can capture the benefits of commodities by going long on commodity indices had better think again, according to one expert in the managed futures industry.

“Volatility, uncertainty, complexity and ambiguity: those are the things you’re going to have to deal with, and the question is, can you deal with them effectively if you are a long-only investor?” said Mark Rzepczynski, president and chief investment officer, John W. Henry & Company, based in Boca Raton, Florida. “I don’t think that you can.”

That may not come as a surprise, since they are to commodity futures what an equity fund manager is to the stock market — and there aren’t many of them advocating investors play the market on their own. But the value a dedicated fund manager brings is widely accepted — leaving aside the active vs. passive debate — and Rzepczynski made a compelling argument in favour of actively managed futures at the Toronto CFA Society’s Commodities: The little known asset class seminar on Tuesday.

“Why do you limit yourself to long-only investing when you could go on both the long and short side of the market?” Rzepczynski asks. “By trading both long and short and by re-weighting the commodities, you’re creating a portfolio that has very low coherence. By changing the weights and making it more evenly distributed, you can create value.”

Commodities have been touted as great diversification vehicles with low correlation to the other assets. These claims are partially correct, but going long on commodity indices will not reap these rewards.

Commodity indices tend to be massively overweighted in the energy sector, due to the sheer value of oil and gas, compared to, say, oats. When oil soars, this weighting can soar to over 60% of the entire index.

“What you want is something that’s broad-based with a lot of commodities, but what you get is something that’s highly dependent on the energy sector,” he said. “You’re not really long-only in commodities; you’re sort of long-only energy with some exposure in other commodities.”

Rzepczynski classifies investments into three main asset classes: those that create wealth, such as equities or bonds; those that are stores of wealth, including the FX market; and production goods, represented by the commodities market.

Unlike other assets, such as debt or equity, he says commodities have no “long bias” that would make an index a buy-and-hold asset. While stocks move up and down, the overall long-term trend is higher. Investors can always hold a bond for its coupon.

“Commodities do not have a long bias. If you’re going to create a long-only portfolio, you’ve got to expect that there is an inherent long bias — it just isn’t there,” he said. “There’s a mean-reversion tendency in commodities based on supply and demand.”

Agriculture provides a perfect illustration of this effect. If the price of canola rises dramatically one year, farmers capable of growing it will often plant canola for the next year to take advantage of the higher price. Assuming no disaster wipes out the crop, the resulting overproduction will drive the price lower.

There is also a demand-side component, as manufacturers will find ways of using less of an expensive commodity and consumers will tend to reduce their consumption of pricey commodities.

Commodity bulls face another challenge from technology. While technological advancements tend to help equities — either the company that developed the technology, or those which will benefit from it — they tend to drive commodity prices lower.

A more energy efficient car, for example, could drive the price of oil lower if it is widely adopted. A technological advancement in the mining sector might lower the mining company’s production costs, but it will also likely bring more of the commodity to market, driving its price lower.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com