As commodities have become increasingly correlated with the broader equity markets, at least one fund is making an effort help commodities maintain their portfolio diversification capabilities.
Launched in December, the Equinox Commodity Strategy Fund Ticker:(EQCAX) separates a universe of 22 commodities into three categories and then uses quantitative formulas to hedge long exposure with short positions.
“The basic philosophy is that we don't believe long-only commodity exposure is appropriate for most investors,” said Ajay Dravid, lead manager of the fund at Equinox Fund Management, a $1.4 billion asset management firm.
While commodities historically have been considered a way to diversify a portfolio, there are a number of reasons related to access that has moved the asset class over the past five years into greater correlation with equities.
According to Mr. Dravid's analysis, the current correlation between the S&P 500 and the S&P GSCI commodities index is at 75%.
But Mr. Dravid's argument against long-only commodities exposure goes beyond just the increased correlation to stocks.
“It's not clear to us that long-only commodities add consistent performance to a portfolio,” he said. “It's not even a genuine asset class.”
The argument that commodities do not qualify as a true asset class is based on the lack of intrinsic value, he added.
“Commodities are inputs into a production process,” he said. “Aside from gold, most commodities will fluctuate in price but not increase in value, because as soon as the price of a commodity reaches a certain limit, people will start to look for alternatives, and that drives the prices back down.”
In order to use commodities as a portfolio diversification tool, the Equinox strategy tracks the SGI Smart Market Neutral Commodities Index, which automatically sells short every long commodity futures contract represented in the S&P GSCI index.
Those short positions are designed to reduce the negative effects of contango, which involves selling expiring contracts for a lower price than the newer contracts that must be purchased to maintain a certain commodities exposure.
Contango and backwardation, which has the opposite effect, are constant realities in commodities investing because futures contracts is the only practical way to invest in most commodities.
The long side of the Equinox fund is separated into three categories based on the characteristics of each commodity.
A seasonal commodity such as heating oil, for example, will be held long during the peak winter months and also held short the rest of the year in a seasonal rolling strategy.
A dynamic rolling strategy is used for something like crude oil, which is extremely volatile. To offset the short exposure that comes from shorting the monthly contracts held by the S&P GSCI benchmark, the SGI Smart index is programmed to look out over several months and go long based on the shape of the price curve.
Then there is the forward rolling strategy for commodities that might be in steep contango such as cocoa, which is experiencing rapidly rising prices.
The plan here is the go long futures contracts that are two months ahead of the contracts held by the S&P GSCI benchmark.
“Going further out on the curve flattens the curve,” Mr. Dravid said. “We are exploiting the structural inefficiencies of the market.”
The Equinox fund is up 1.5% from the start of the year, which compares with a 3.8% decline by both the S&P GSCI and the S&P 500 over the same period.
Portfolio Manager Perspectives are regular interviews with some of the most respected and influential fund managers in the investment industry. For more information, please visit InvestmentNews.com/pmperspectives.
