Clive Capital is jumping on board the dynamic commodity indexing bus alongside Goldman Sachs.
As the FT reported on Monday:
Goldman Sachs, the bank that popularised commodities investing among pension funds and other conservative money managers, is to launch a commodities index in conjunction with Clive Capital, the largest commodities hedge fund.
The index, which Goldman has started marketing to its clients, will attempt to minimise the risk of large losses by altering its exposure to individual commodities over time. It will be marketed to risk-averse institutional investors such as pension funds, foundations and endowments.
It is the latest in a new generation of commodities investment products known as “active” or “dynamic” indices which are able to shift their holdings as the markets change. The launch comes as investors, who have become increasingly knowledgeable about commodities after a decade of rising prices, are growing cautious that slowing demand growth in the US, Europe and China may interrupt the boom.
The idea is basically that Clive Capital, using its commodity expertise, will redetermine the weighting of the index ever month — or rather, determine how much money to allocate into each commodity and in which way.
The hedge fund won’t be able to opt out of commodities altogether, or short them. Just minimise or maximise exposures among the already prescribed constituents. It will in some cases be able to go to zero allocation for some constituents which have a low enough weighting.
From the investor’s point of view, the dynamic feature should facilitate exposure to the outperformance of specific commodities and/or protect from the under-performance of others. The downside, however, is that it exposes the investor to the ability of Clive Capital to call the market correctly.
As the FT noted, the hedge fund lost 8.9 per cent — some $400m — during May’s blockbuster oil plunge. Not necessarily all that confidence inspiring.
John Kemp at Reuters goes one step further in his criticism.
Rather than exposing the investor, as the marketing implies, to the best of both worlds — predictability, transparency and the superior returns of an actively managed commodity fund — the indices potentially expose investors to the worst of both approaches, says Kemp.
The concept of a dynamic index is a contradiction in terms. The more they behave like a hedge fund the less they will resemble a traditional index product. Third generation indices are likely to suffer all the problems that plagued the first and second generations without capturing the full advantages of discretionary management or a hedge fund. The real danger is that these indices will be uniquely vulnerable to front-running and becoming ensnared in bubbles and crowded trades. Rather than being first in and first out, riding market momentum, investors in a dynamic index risk being last in and last out — market followers stranded long and wrong at the top after true hedge funds have exploited their momentum and cashed out.
Indeed, Kemp notes there’s also a high probability that the indices are being specifically designed to attract money from pension funds and others usually not allowed to invest in hedge fund strategies via the comfort blanket of an index wrapper.
The question is whether a simple index wrapper is enough to mitigate the risks? Or, more to the point, whether a dynamic index will really help institutional money avoid the problems associated with past commodity index incarnations?
As Kemp notes:
Index strategies have fallen prey to two problems: (1) the sheer volume of money chasing the same strategy has forced many markets into contango (or smaller backwardations) cutting roll returns and in some cases turning them into roll costs; and (2) the extended period of ultra-low interest rates as a result of the financial crisis has slashed collateral yields.
While the dynamic indices will try to avoid some of these issues by choosing where on the futures curve to place their exposure, or by rotating their allocations between commodities, Kemp says there is still a risk they will end up responding to the same old signals, creating the same old ‘bull in a china shop’ problems:
They will all swarm into the same commodities at the same time, in huge volume, moving the market against themselves, quickly competing away the very returns that drew them in the first place.
Which does make you wonder who exactly the true beneficiaries of the indices will be? In Kemp’s view the answer is obvious:
Index managers and operators insist they have strict Chinese Walls in place and other safeguards to prevent investors from being front-run by in-house traders and associates. But in reality it will be easy for operators, associates and totally independent third parties to front-run the indices. In fact it will be hard not to and would require them to act irrationally.
Indeed, why else would a hedge fund or a trading house be interested in the indexing business?
Related links:
The holy grail of ETFs - FT Alphaville
Credit Suisse, Glencore Launch Active Commodity Index - Index Universe