understanding

commodities

Products & Solutions Alternative Investments

understanding commodities

3

introduction Commodities are the world’s raw materials. As natural resources, they are used in the production process of all manufactured goods, putting them at the heart of the economic cycle. The vital role in the world’s economy, combined with the specific characteristics of commodity markets, make this an asset class that can add real value to your investment portfolio. This brochure explains why and how to invest in commodities.

understanding commodities

5

what are

commodities? Commodities are our planet’s natural resources. The raw

Commodity markets

materials in every product we use. The grains in our food,

Consumers and producers meet in the marketplace to buy

the wooden table on which that food is served, the steel

and sell commodities. Demand and supply factors (and related

in the car outside the restaurant. There are many different

uncertainties) determine the mechanics of the commodity

commodities and many different commodity classifications.

markets, and therefore of commodity prices.

From non-perishable or ‘hard’ commodities, such as metals, to

Each commodity has its own, very distinct marketplace. The

perishable ‘soft’ commodities, such as agricultural products.

supply and demand factors for wheat are very different from

At ABN AMRO, we break the world of commodities down into

those for crude oil, which in turn differ greatly from those for

the following six categories:

palladium.

Categories

Typical examples

Standardisation

Energy

Crude oil, natural gas, gasoline, power

A key element in the larger commodity markets is

Precious metals

Gold, silver, platinum, palladium

standardisation. Commodities are traded in standard quantities

Base metals

Aluminum, copper, nickel

with a pre-defined quality level. This means that worldwide a

Ferrous metals

Steel, iron ore

buyer of bushels of wheat knows exactly what he is getting,

Agricultural

Wheat, coffee, cocoa, sugar

regardless of who produced the commodity. This knowledge

Livestock

Feeder cattle, live cattle, lean hogs

has a major positive impact on that commodity’s tradability and liquidity.

Commodity supply and demand

One commodity with very high consumption levels but a

Commodities are clearly crucial in everyone’s daily life.

small market is rice. Rice grown in Thailand differs in type

Without food, we cannot eat. Without energy many aspects

and characteristics from that grown in Japan or India.

of developed society cease to function. This fundamental

Standardisation is therefore not possible and global trading

role of natural resources is a strong driver of demand for

difficult. The market for crude oil, on the other hand, is so large

commodities. A demand that will only intensify with the

it sustains two global standards: Brent and WTI crude oil.

world’s growing population, increasing urbanization and rising living standards. Trends to which emerging markets like China are contributing heavily. As producers such as mining and oil companies or largescale farms try to meet this growing demand, their output relies on the availability of and their access to the relevant commodities. A variety of factors play an important role here, including weather conditions and regulations; as well as the geo-political environment, as seen for example in 2011, when unrest in oil-producing countries affected oil prices. The economic cycle is important to both commodities consumption and production. If the economic outlook is less positive, people tend to buy fewer products and so consume fewer

commodities. When

economies

are

booming,

consumption rises. Producers try to balance their supply with shorter and longer-term fluctuations in demand. For example, by managing inventories of commodities that can be stored; or by investing in new mines or plants.

Oil Crude oil is the name of the raw material found in an oil well. It

capacity in known oil fields. Demand depends very much

is often used as a generic term, but characteristics of ‘crudes’

on the economic cycle and consumer sentiment. Risks in oil

can vary considerably from oil field to oil field. The most

prices are also dependent on the geopolitical situation in the

important measures of quality are sulphur content and gravity.

countries where pipelines, reserves, oil fields and refineries

The most valuable crudes are those with low sulphur content

are located.

and low gravity. ‘Sweet crudes’ are those with 0.5% sulphur content or less, ‘sour crudes’ have a sulphur content of 1.5% or more. The widely traded West Texas Intermediate (WTI)

Boiling range

and Brent Crude Oil are both high quality. While the heavier

Less than 30°C

LPG’s: butanes, propanes & lighter

sour crudes from the United Arab Emirates and Mexico are

30°C to 160°C

Gasoline (petrol), naphtha

poorer quality, and thus traded at a discount to lighter grades.

160°C to 250°C

Kerosene, jet fuel

Crude oil is a mixture of hundreds of different types of

250°C to 400°C

Diesel, gas, fuel & heating oils

hydrocarbons with carbon chains of different lengths. These

400°C and higher

Residue, coke, asphalt, tar, waxes

Fraction of crude oil

can be separated through refining, using the different boiling of hydrocarbons in crudes varies between oil fields, refinery output of oil products depends on the crude used. And as each refined oil product has a specific purpose, this in turn determines the demand for that product, and so indirectly for the crude itself.

Crude oil prices Spot prices (USD)

temperatures of the output oil products. Because the mix

160 140

100 80

This was driven primarily by the dominant US gasoline market,

60

Asia’s increased demand for other distillates, Brent currently enjoys the higher prices. Nevertheless, as with any market, the current situation may change as other factors emerge causing new price developments. Oil prices are determined by (expected) supply and demand. But also by reserves held in various locations and spare

Brent Crude Oil

120

In the past, demand for West Texas Intermediate was highest. as WTI yields more gasoline products than Brent. But since

WTI Crude Oil

40 20 0 1990

1995

2000

2005

2010

Source: Bloomberg The evolution of spot prices is shown for WTI Crude Oil and Brent Crude Oil.

understanding commodities

7

investing in commodities advantages and risks

Advantages

Risks

Historically, commodities like precious metals have always

Despite these advantages, investors need to be careful, as

been valued by people as important possessions, often as

investing in commodities also carries considerable risks:

jewellery. Today, private investors are increasingly keen to

XXBecause

own commodities alongside their investment portfolio. The main reasons for this trend being: XXCommodities

offer diversification within the overall

investment portfolio. XXThe

fundamental link between the economic cycle,

commodities and inflation means investing in real assets offers some protection from inflation. XXCommodities

can from time to time offer considerable

returns, though prices are volatile.

the volatility in commodity returns is generally

high, adverse market circumstances can result in losses. XXThe

fundamental characteristics and mechanics of

commodity markets can evaporate in times of market stress. For example, the correlation with other asset classes, normally low, may increase in times of crisis. XXThe

market for some individual commodities is not large,

which can lead to liquidity risk. XXInvesting

in individual commodities through sophisticated

instruments like derivatives requires specific knowledge and expertise. To provide an alternative, ABN AMRO has selected a range of products that are suitable and accessible for a broad spectrum of investors.

8

why invest in commodities?

Correlations between commodities

commodities are different from those of stocks and bonds.

As we have seen, each commodity has its own very distinct

For example, if commodity prices increase, the profit margin

set of price drivers. Unique demand and supply factors

for relevant companies may reduce in the short-term if they

(and related uncertainties) determine the mechanics of

cannot pass on those higher costs to their customers. Thus

each individual commodity market. Correlations between

reducing the stock price of such companies.

individual commodities are therefore typically low. Though

Equally, if commodities suddenly become more expensive,

unsurprisingly, the correlation between various oil products is

there will be an unexpected rise in inflation levels. Causing the

larger than that between crude oil and, say, wheat.

value of a bond to decrease, because the purchasing power

The benefit of this low correlation is potentially a reduced

of the bond’s future interest payments and principal are now

overall risk in your commodity investment: discovery of new

lower than anticipated at the time of issue.

nickel resources may bring down the nickel price, but will have

When applied well, these low correlations can reduce the

little effect on natural gas prices.

risk in an investment portfolio. Introducing a moderately-

So for your portfolio, it is best to invest in a number of different

sized position in commodities to your portfolio may reduce

commodities at the same time. This protects you to some

the overall risk and may increase returns. This diversification

extent from adverse events in a specific commodity market.

technique should always be applied carefully: too-large a

Making the ups and downs of your overall position less

position in commodities, where they become dominant, can

extreme, and the risk/return profile more stable.

actually increase your overall risk. Since the 2008 economic crisis, the correlation between

Correlations with other financial assets

commodities and other financial assets has been higher than

Commodities not only have a low correlation with each other.

before. Many investors had entered commodity markets

They also have a low correlation with other financial assets,

looking for high returns for the purpose of investing or

such as stocks and bonds. This is because the price drivers for

speculating, not out of interest in the commodities themselves for use in production processes. This resulted in markets that were financially-driven rather than fundamentally-driven.

Annual return

Risk/return for individual commodities

many investors abandoned risky assets, there was a sell-off of

30% Heating Oil 25% Silver Copper

20% 15%

Natural Gas

Crude Oil (WTI)

Wheat

stocks and commodities alike. But despite this sell-off, many commodity markets still performed better than stocks in 2008. So investors with a diversified portfolio containing commodities were still

Gold TR/J CRB

better off.

Coffee

10%

The link with inflation

Prime aluminium 5% 0% 0%

When subsequently the stress on financial markets grew, and

There is a fundamental link between commodities and the economic cycle, which we also see in the link between 10%

20%

30%

40%

50% 60% 70% Risk /annual volatility

Source: Bloomberg Annualized volatility vs. annualized returns, calculated with month-on-month returns from 1 February 1999 to 31 October 2011. Individual commodity contracts are shown together with the TR/J CRB Index, which represents investment in a basket of commodities. As can be seen, investment in such a basket tends to reduce your risk though at the cost of some returns.

commodities and inflation. When the economy is growing, higher income per person generally leads to increased purchasing power. This raises the demand for end-products, which in turn raises demand for commodities (higher income also leads to more spending on luxury products). Higher demand for commodities leads to

understanding commodities

9

higher commodity prices. So consumers have to pay more

Historical performance

for their goods over the longer-term, as manufacturers of end-

Historical data show that the performance of commodities

products seek to maintain their longer-term margins. So we

have been quite attractive, though there have also been periods

see how rising commodity prices can cause inflation.

with little returns. Over the last decade, the performance of

These links between the economic cycle and commodities can

the commodity benchmark has been in double digits. The

to some extent protect commodity investors from inflation, as

downside to this attractive performance is considerable

investing in real assets makes you less dependent on price

volatility, which has also delivered some high negative returns

levels. However the connection between the economic cycle

in recent years. And some commodity markets are relatively

and commodity prices is not perfect, as the 2008 crisis made

small, adding to the volatility profile.

clear, and so any protection from inflation will also not be

These dynamics make it crucial for the private investor to

perfect.

approach commodities with caution. Nevertheless, it cannot be denied that the high performance has been attracting investors. For some approaches to balancing caution and attraction, see the next chapter.

Gold Timeless treasure

in the first half of the year, gold positions were increased by

For millennia gold has been used as a store of value, a unit of

investors looking for the traditional ‘safe haven’. But significant

exchange and in jewellery. It is the most malleable and ductile

assets were also invested in gold by speculative investors

known metal: a single gram of gold can be beaten into a sheet

looking for high returns. This drove up the price to all-time

of one metre square or a wire more than a mile long. Gold is

highs. Around the end of the summer there were positive

also a good conductor of heat and electricity, and unaffected

signs of economic stability in Europe. Speculative investors in

by air, heat, moisture and most solvents.

particular began selling their positions to take their profits. The

Most gold consumption is in the jewellery sector. Alloys

gold price declined sharply to pre-summer levels. Between

of gold with silver, copper and other metals are common

23 August and 26 September, the price fell 15.7% (the short

because pure gold is too soft for ordinary use. When used in

timeframe makes this difficult to see in the graph below). The

jewellery, gold is measured in karats: pure gold is 24 karat,

numbers of investors had been so large, with many of them

lower numbers indicate higher copper or silver content.

having speculative goals, that gold’s ‘safe haven’ status was

Because for example of its electrical conductivity, resistance

lost. Gold became a risky asset.

to corrosion and reflective properties, gold has a variety of industrial uses, including in electrical connectors, electronics, restorative dentistry, medical applications, chemistry and photography.

Spot price of gold 2,000

Historical stability The gold price has long been closely linked to the US Dollar

1,500

and the level of inflation-corrected interest rates in the United States. Historically, positions in gold have been relatively stable compared, for example, to stock markets. Gold is therefore

1,000

often referred to as a ‘safe haven’ for investors in troublesome times. In short, it exhibits very different characteristics to all

500

other commodities.

Not-so-safe haven During the summer of 2011, gold lost some of its reputation as a safe haven. As the economic situation in Europe deteriorated

0 1975

1980

1985

1990

1995

2000

2005

Source: Bloomberg The actual nominal spot price evolution of gold is shown, in USD.

2010

10

Tracking the performance of commodity markets There are a number of frequently used benchmark indices, all of which track the general performance of the commodity markets. The benchmark for commodity investments for ABN AMRO Research & Strategy is the Thomson Reuters/ Jefferies CRB Index (‘the CRB’). Launched in 1957, this is probably the oldest of all commodity indices.

Thomson Reuters/Jefferies CRB Index (EUR) 350 300 250

The performance of the CRB index is shown on the right. Though the considerable price appreciation from 1 February

200

1999 to 31 October 2011 has reached 12.3% per year, it is

150

worth noting the annual volatility in month-on-month returns

100

is also significant: 18.1%. The CRB index has a stated objective of providing timely and

accurate

representation

of

a

long-only,

broadly

diversified investment in commodities through a transparent methodology. It aims to be a liquid and economically relevant

50 0 1999

2001

2003

2005

2007

2009

2011

Source: Bloomberg

benchmark. The CRB consists of a portfolio of 19 different commodity

Weights of commodities in the CRB index

Future contracts that are replaced or ‘rolled’ according to a standard monthly schedule. As with most indices, the CRB

Energy - 39%

takes Futures that are close to settlement (i.e. at the front of the Futures curve and close to the Spot Price). As a Total

Precious metals - 7%

Return index, it also earns a collateral yield equal to the 91-day Base metals - 13%

US Treasury Bill. The weight of every commodity in the overall CRB portfolio

Agriculturals - 34%

is reset every month, at the time of the rolling of Futures contracts. These weights are pre-defined and rarely changed,

Livestock - 7%

which is unique to the CRB. Other indices adapt their weights more frequently. The main difference between the various benchmark indices lies in the specific number and weights of individual commodities. The CRB is a highly averaged, well-diversified index. Other indices have an above-average allocation of certain individual commodities. This is the main reason ABN AMRO Research & Strategy has chosen the CRB as its benchmark.

Source: Thomson Reuters

understanding commodities

11

different approaches

to commodity investment

The low correlations between individual commodities, plus

Trading

the combination of high risks and potentially high returns,

For a specific group of private investors, a more dynamic,

have implications for what your most appropriate approach to

trading-like approach to commodity investing may be attractive.

commodity investing should be.

Typically, such investors look to build their own portfolio of individual commodities with sophisticated instruments.

Diversification

Aiming to benefit from the volatility in commodity prices to

For most private investors, the preferred option is a position

get returns. For them, portfolio diversification is perhaps only

well-diversified across a range of individual commodities.

a secondary objective.

This gives you the maximum benefit from the diversification

Generally, this type of investing requires a higher level

effect. The low correlation between commodities is key here.

of knowledge of individual commodities and financial

As mentioned, a moderately-sized position in commodities

instruments. Such private investors also usually have a high

does add strategic value to your portfolio. However, the

risk tolerance for their portfolio. This approach also requires

outlook for commodities (and the economy as a whole) may

active portfolio management to address the high volatility in

at times be such that a tactical increase or decrease in that

commodity markets.

strategic position is advisable. This can occasionally mean reducing the tactical share of commodities in the portfolio to 0%. Or at other times increasing the tactical share until it is larger than the strategic allocation to pursue a greater benefit from a particularly attractive performance within this asset class.

Thematic investment Once portfolio diversification has been achieved, and the markets seem right, private investors may want to add a thematic investment to their position. For example, research may show significant opportunities in a single commodity. If the rationale is strong enough, a thematic solution could be appropriate. For most private investors, such thematic investments are only suitable if made as an addition to an already well-diversified commodity position, and the thematic investments do not then erode that diversification.

12

Will investment in commodity-related stocks give exposure to commodities? Buying stocks of commodity-producing companies does give exposure to the mechanics of the commodity markets, but also to equity-related risks. Such companies are rarely pure investments in the raw materials they produce. This is because they diversify their business model and the efficiency of their production process is not necessarily in line with the value of the raw materials they produce. They may also hedge their exposure to price movements, further reducing any relationship with the prices of the respective commodities. For these reasons, stocks of commodity-producing companies are not classified as commodities, but as a separate sector within the equity asset class.

Price indexed at 1 February 1999

Stock versus commodity prices 1,200 1,000

Spot price Crude Oil (Brent) Royal Dutch Shell MSCI World Index

800 600 400 200 0 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Source: Bloomberg. The price evolution for a number of securities is shown, after having been normalized/indexed to a value of 100 at 1 February 1999, for comparison purposes. This demonstrates the high correlation of Royal Dutch Shell with the equity market, as opposed to the low correlation with the oil price.

understanding commodities

13

how to get

commodity exposure? For private investors considering exposure to commodities,

date. This is called ‘rolling your futures position’.

there are several types of solutions available. However, one

Investing directly in futures requires an active management of

thing all commodities have in common is that they do not

your portfolio, with higher levels of investor knowledge and

return any income or dividend. This makes them a different

experience. Similar, but less regulated, ‘Forward contracts’

sort of investment from stocks or bonds: all changes in the

are also sometimes used.

value of a commodity position are derived from price evolution in the underlying commodities.

Indirect commodity investing

See the next section for more on the source of returns for

Indirectly investing in a (managed) portfolio of futures is

commodities and futures.

perhaps the most common approach for private investors. Here the investor buys a share in an investment vehicle, for

Investing in physical assets

example a fund, for which the performance is determined by

Buying actual, physical commodities is the most basic

a portfolio of commodity futures.

approach. Though this may be the best option for producers

For a private investor, this method can offer a relatively

and consumers of raw materials, for private investors it is

low-cost exposure to commodity markets via the expertise

often unrealistic: most of us don’t have the means to store

of specialists. Another advantage is that you do not need

large quantities of cattle or oil! For certain precious metals,

detailed knowledge or experience with futures.

however, there are solutions available to invest in physical

As with propositions in other asset classes, the portfolio

goods: gold coins and bars are available on the market, and

itself can be constructed in a variety of ways. The portfolio

some specialist banks offer gold accounts in various formats.

manager’s investment strategy can range from very active to

For easy-to-store commodities, like precious metals, some

fully passive, and apply a ‘long’ or ‘long/short’ strategy.

exchange traded products (ETP’s) have also been developed.

The legal structure of the vehicle can also vary. Examples

These store the commodity and issue an exchange traded

include long-only investment funds, ETFs, certificates,

vehicle, the performance of which depends on the market

commodity-linked bonds, hedge funds and managed accounts.

price of the underlying commodity.

In most cases, product providers set up their solution as an investment fund.

Investing with futures Instead of buying physical goods that are delivered the same day, an investor can enter into a contract where he agrees on delivery at a later date. The payment is then settled on that later date. Such ‘futures’ contracts are common in commodity markets. Producers and consumers often use them to manage the timing of delivery of actual commodities. They also use futures to reduce their exposure to changes in commodity prices, by ‘hedging’ their positions. Effectively they lock in today’s price for the sale, rather than be dependent on the market price at the time of delivery. For the private investor, futures can be used to avoid the need for physical storage. But as the settlement date approaches, the investor must sell the future to avoid actual delivery. As a next step, and to maintain exposure to the commodity, the investor can buy a new future with a new, later settlement

understanding commodities

15

which investment strategy is right for me?

When investing in a portfolio of commodity futures, you

Choosing a product

can choose between various investment strategies. Classic,

When considering investment in a commodity product as a

enhanced and active commodity products differ in having

private investor, you need to decide which of the strategies

a fixed, flexible but pre-determined, or human approach to

above suits you.

deciding in which the futures contracts to invest.

If exposure to the commodity market is all you want to achieve, you would normally invest in a passive product. If, however,

Classic commodity strategies

you believe in the upside potential of active management, you

Classic products are passive. Futures contracts are bought

should invest in an active product.

and sold on the basis of a predefined, fixed schedule.

If you don’t have a strong preference for either of these

These products have the simplest and most transparent

options, you might want to base your decision on a comparison

methodologies. Private investors aiming only for market

of the risk-and-return characteristics of several solutions.

exposure through benchmark indices, typically choose classic

Whatever you decide, you should only select a product that is

products.

consistently delivering what has been promised and that has been set up in a sound manner.

Enhanced commodity strategies

Important elements for the selection of the most appropriate

Enhanced products use quantitative methodologies and

solution include: the individual commodities used in the

decision rules to determine which futures to buy and sell. They

strategy, their respective weights in the portfolio, the roll

aim to be more flexible than classic products. By selecting the

schedule for the futures positions, etc. These elements are

most appropriate future contract, and in some cases by also

all very specific to the unique characteristics of commodities.

changing the weights of individual commodities in the portfolio. The decision about which futures to invest in is typically based

Investment vehicles

on ‘decision rules’ or formulas. These rules or formulas can be

As with any product, there are other more general criteria to

constructed on the basis of, for example, fundamental economic

be considered. Including the set-up of the investment vehicle,

research, seasonality or trend analysis. Input parameters for

costs and fees, the company providing the structure, the track

rules or formulas may also come from economic data, trend

record of the manager, the liquidity profile of the product, and

data, etc. Most enhanced commodity products try to optimize

so on. Exchange Traded Funds (ETFs) and Exchange Traded

the roll yield, avoiding ‘contango’ and making optimal use of

Products (ETPs) are common vehicles for classic commodity

‘backwardation’ (see ‘In the depth: returns on commodity

products. ETPs invest in physical commodities, managing the

futures’ for an explanation of these concepts).

storage of goods. ETFs generally invest in swap structures, where the fund receives the performance of an agreed

Active commodity strategies

benchmark index from the swap counter-party, in return for

Rather than simply a systematic or mechanical method for

providing the performance of a basket of collateral.

taking decisions, active products have some element of

Similar swap structures are also used for enhanced commodity

human intervention. This human intervention can be used to

products. The performance returned by the swap counterparty

change weights of individual commodities or to select specific

here depends on the enhanced strategy. Note that there are

commodity contracts to be bought and sold.

various types of swap structures. Each with its own specific

With these products, too, decisions about which futures to

risks and benefits that you should bear in mind before investing.

invest in can be based on fundamental economic research or

Most often, the investment vehicle will be a fund.

any other type of analysis. The common factor is that some

Active commodity products are more likely to invest directly

judgement or estimation is required, based on the belief that

in futures. These products are mostly managed by specialist

models cannot be right in all market circumstances.

investment managers, using a fund structure as the investment vehicle.

16

in depth:

returns on commodity futures Investing in a portfolio of commodity futures brings with

Storage costs and foregone interest earnings are also

it some unique performance specifics. Instead of buying

discounted in the price. These are larger when the settlement

physical goods that are delivered the same day, the investor

date is further away, though generally storage costs are

enters into a contract with a later settlement date. To avoid

marginal to the fundamental value of the commodity.

the delivery of physical goods on this settlement date, futures

To better understand the performance of futures, Excess

have to be bought and sold on an active basis. This has an

Return is often analyzed from different perspectives. The two

impact on the price evolution. Another distinctive feature of

components most often used being the Spot Return and the

these instruments and this asset class is that commodities

Roll Yield.

futures do not provide an income return.

Spot Return Excess Return

The Spot Price is the price for immediate delivery of that

Because commodities don’t provide any dividend or other

commodity. Essentially, it represents today’s fundamental

income return, all changes in the value of a futures portfolio

value of the commodity. The Spot Price is also the commodity

are related to the price evolution of the futures.

price generally quoted in the media. A good proxy for the Spot

The price of a future depends mainly on the expectations of

Price is the future that is closest to settlement.

the market regarding the fundamental value of the underlying

Normally when the Spot Price changes, the price of all futures

commodity at the date of settlement. When an investor holds

with later settlement dates also change, by approximately the

a future and the price of that future changes, the investor

same amount. So part of the performance of a commodity

incurs a profit or a loss at the time he sells that future. The

future can be explained by the ‘Spot Return’, which is equal to

profit or loss materializes because the expectation of the

the evolution of the Spot Price.

market has changed. This profit or loss is called the ‘Excess Return’.

Roll Yield Typically, the future price for a nearby settlement date is not the same as the future price for a settlement date further

Gold futures prices

away. This means that the market expects a certain evolution in the fundamental value of the commodity over time. The

1,720

‘futures curve’ is therefore not normally a straight line but a true curve which may go up or down, or both.

1,700

Even where the futures curve remains exactly the same over 1,680

time, with the Spot Price remaining constant, its curvature implies a change in the price of a specific future as it comes

1,660

closer to settlement. This change in price is called the Roll Yield. A futures curve with an upward slope is said to be in

1,640

‘contango’. Here the futures price is lower for futures closer 1,620

to settlement, which means that the Roll Yield is negative. A futures curve with a downward slope is said to be in a state

1,600 1/10/2011 1/6/2012 1/2/2013 1/10/2013 1/6/2014 1/2/2015 Source: Bloomberg A ‘futures curve’ shows the prices of a series of futures, as they are trading on certain dates. In the example above, the prices of the gold futures are shown, as per 31 July 2011. On that day, the market agreed a price of 1636 USD for the future settling on 1 June 2012. On the same day, the market also agreed a price of 1650 USD for Gold delivered on 1 June 2013.

of ‘backwardation’. Here the futures price is increasing as the futures come closer to settlement, which means the Roll Yield is positive.

understanding commodities

17

As indicated above, excess return can be explained for a

Because settlement occurs at a later stage, the full price does

large part by Spot Return and Roll Yield. These measures

not need to be paid at the time a future is bought. Only a

may counterbalance or strengthen each other. In principle,

small percentage of the portfolio is required as deposit with a

all positive Spot Returns can be cancelled by a negative Roll

Clearinghouse (the ‘collateral margin’). The rest of the portfolio

Yield, and vice versa.

can be invested separately, though it must be kept relatively

Historically, Roll Yield has been a significant contributor, both

safe and liquid in order to meet the obligations of the portfolio

positive and negative, to commodity performances. Investors

as a whole.

therefore often try to be smart about this concept when

Both the collateral margin and the share of the portfolio

entering into a position. For example, they may choose to both

not deposited with the Clearinghouse (together 100%

buy and sell specific contracts on the futures curve, timing the

of the portfolio value) are generally invested in relatively

transactions to optimize the Roll Yield.

safe instruments, such as short-term US Treasury Bills.

Note that with Roll Yield and Spot Return, not all changes in

The corresponding return is called the ‘Collateral Yield’ and

the futures prices are taken into account. Although futures

counted as part of the return of a futures portfolio.

curves tend to be relatively stable in terms of shape, changes

The combination of Excess Return and Collateral Yield is

do sometimes occur. A significant change in a futures curve

called the Total Return. This is the type of return provided by

would be from a state of contango to one of backwardation.

most commodity solutions. Though investment solutions are

This would have an effect on the Excess Return that is only

also available that only generate the Excess Return, or even

partly reflected in Spot Return and Roll Yield.

specifically the Spot Return.

Contango

Backwardation price

Collateral Yield and Total Return

price

Excess Return: conclusions

“contango”

0

1

2 3 # months to expiration

4

“backwardation”

0

1

2 3 # months to expiration

4

18

ABN AMRO Private Banking

Commodities are part of the asset classes covered by

For most private investors, diversification will be the main

ABN AMRO’s Global Investment Policy. Recommendations

objective. This is ideally achieved by investing indirectly in

are given on the strategic and tactical allocations to the asset

commodities (indicated by the shaded area in the table). The

class within investment portfolios. Commodities are covered

most common instruments for this purpose are investment

in ABN AMRO’s Quarterly Outlook and other investment

funds. ETFs or Structured Products may also be appropriate

research, and in other strategy and research publications.

solutions.

Within ABN AMRO Private Banking, considerable effort is

With these instruments, the investor can choose from

spent selecting the most appropriate commodity solutions

various investment strategies: Classic, Enhanced and/or

for private investors. Dedicated expertise is available within

Active. Funds may adopt any one of these three strategies,

AA Advisors to provide a selection of commodity funds:

but ETFs or Structured Products typically only carry either

both the investment proposition and the operational set-up

Classic or Enhanced strategies. After you have determined

are assessed. In addition, the Structured Products teams are

your objective in commodity investing, the next step is to

always ready to set up solutions where specific opportunities

decide which investment strategy to follow. This will depend,

arise.

among other things, on your preferences and your risk/return

Product specialists in both our local and global organizations

profile. These factors will in turn help you determine which

will be happy to help if you have any questions regarding

specific solution and instrument is most appropriate for your

commodities. They can also advise on the most appropriate

circumstances.

commodity solution for your portfolio, leveraging the

Each of the three investment strategies has its purpose. You

knowledge and expertise available across the entire

should select on the basis of whether you wish to stay close to

ABN AMRO organization.

the commodity benchmark (Classic), to be more flexible than

The table below gives an overview of the most common

the benchmark (Enhanced), or to have the upside potential of

instruments used by private investors in the commodity

active management (Active). ABN AMRO offers its clients a

markets, aligned with their varying objectives within

product range with appropriate solutions for each investment

commodity investing.

strategy.

Instruments for commodity investors

Objectives of commodity investors Diversification

Thematic investing

Trading

Long-term positions in a range of

Medium-term positions in individual

Short-term positions, requiring active

commodities, aiming at improving the

commodities, preferably in addition to a portfolio management, specific

risk/return balance of the portfolio

long-term diversified portfolio

expertise, and typically a larger risk tolerance

Types of commodity solutions

Investing in physical assets

Gold bars, gold and silver coins (intended as ‘safe haven’ investment, diversifying across asset classes)

Investing in futures

Indirect commodity investing (i.e. with instruments linked to commodities)

Futures (long and short), forwards

Funds, ETFs, structured products

Funds, ETFs / ETPs, structured products

ETFs / ETPs, turbos

understanding commodities

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19

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