“Serious doubts” raised about hedging potential of long-only commodities

Regular readers of this website know that managed futures strategies have almost always provided a stellar downside protection when the equity markets fall out of bed.  While many managed futures funds trade in physical commodity futures, many others trade in futures based on financial instruments.  Still, many (including, admittedly, us) sometimes treat managed futures as a hedged version of long-only commodity investing, like comparing a market neutral equity fund to a long-only equity fund.

But an article in the Winter 2011 edition of the Journal of Alternative Investments provides some helpful clarity on this topic.  In “Protection Potential of Commodity Hedge Funds,” Pierre Jeanneret and Stefan Scholz of Man Investments team up with Pierre Monnin of Swiss National Bank to create an index comprised solely of hedge funds that trade in commodities. (Available for free by registering at CAIA.org ^[2], then clicking here ^[3].)  What they found both confirms intuition and challenges our thinking on the downside protection of commodities.

Firstly, they reaffirm the notion that commodity hedge funds have outperformed long-only commodities over the past decade.  They create a new index of all types of hedge funds (not CTAs) that report to invest in commodities via futures, equities, options, fixed income, etc.  This “peer” group contained 92 funds.  As you can see from the chart below, they creamed long-only commodities indexes such as the S&P/GSCI.

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You can see that the trio’s proprietary “commodity hedge fund” index had some serious downside protection during the financial crisis.  As a result, it has basically regained all of it’s (modest) loss since 2008.

So did the managers of these hedge funds reverse their exposure at exactly the right time?  Not really.  In fact, the chart below from the article shows that the 24-month rolling correlation between the commodity hedge fund index and various long-only indexes remained largely unchanged during the financial crisis.

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So what gives?  How did these commodity hedge funds beat their long-only brethren so handily during the crisis?  The answer is that they took some serious volatility off the table.

Recall that beta is a factor of benchmark correlation (above) and volatility relative to that benchmark.  By dramatically reducing volatility during the credit crisis by, for example, moving quickly into cash, the commodity hedge funds managed to reduce their beta very quickly during 2008  - note that this actually began in early 2008, even before the full brunt of the financial crisis hit.

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Other charts in the article by Jeanneret, Monnin and Scholz show that this was indeed true.  Amazingly, the annualized standard deviation of their new commodity hedge fund index (on a rolling 24-month basis) remained at historical averages of around 10% during 2008, while the annualized standard deviation of the various long-only commodities indexes spiked to around 30% in late 2008 – and remains there today.

The bottom line is that the ability for commodity-focus hedge funds to take money off the table seems to have been a significant advantage.  The chart below created with data from Exhibit 1 of the article makes the point.  Notice how a high volatility seems to buy you a low return when it comes to long-only commodity index investing. CAPM be damned!

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The article concludes with an interesting discussion about the true ability of long-only commodity investments compared to hedge inflation.  While commodities are generally thought of as a hedge againstinflation, Jeanneret, Monnin and Scholz show that over the past decade this has only been true when “inflation surprises are positive,” or when inflation comes in lower than was anticipated.  Put another way, long-only commodity investments can hedge expected inflation, but are relatively powerless against inflation surprises.  The trio is quick to point out that the past decade has been a period of low inflation and so their results need to be taken with a grain of salt.  Nonetheless, they write, the results “…raise some serious doubts about the hedging potential of long only commodity investments…”