US commodity ETF proposals could boost flows to Asia, says Credit Suisse

Asian commodity markets could benefit if the US were to bring in certain commodity-trading rules currently under discussion, says Andrew Karsh, New York-based co-lead portfolio manager of Credit Suisse’s total commodity return strategy.

He suggests that commodity-trading flows to Asia, which are already gradually increasing, could gather speed if position limits for exchange-traded commodity futures were imposed. The proposals were unveiled in January and would affect crude oil, natural gas, heating oil and gasoline.

There are already more commodity-investment managers accessing Asian markets than a few years ago, says Karsh, and if commodity traders at banks or asset managers could gain outperformance from using local exchanges in Asia, firms would move quickly to utilise these channels while looking to access flows from investors based in the region.

Of course, Asia itself is not free of regulatory intervention in the commodity markets -- take India’s banning of futures contracts in certain commodities in 2008 in an attempt to cool the price of products such as rice, wheat, soy oil and rubber. Clearly, then, firms looking to trade on Asian exchanges will weigh up the potential downsides of trading in certain markets in the region. 

Nevertheless, commodity investments are growing in popularity in Asia as both a diversification tool and a hedge against inflation. That’s despite the fact that the benefits of commodities as a portfolio diversifier came into question during the recent financial crisis, as the correlation between equities and commodity prices rose significantly in 2008 -- that was only the third year since 1970 that commodity and stock indices fell in the same year.

Still, Karsh argues that commodities are a form of inflation insurance, particularly against unexpected inflation, as well as a portfolio-diversification tool. The best approach, he adds, is to be exposed to a broad basket of commodities

That way, the investor gets a wide range of volatility, says Karsh – for example, natural gas has a typical historical volatility of 55%, while that of lean hog prices is 12%. For example, the commonly benchmarked DJ-UBS Commodity Index comprises 19 components. Given those components' different volatility levels and low correlation to each other, investors in a basket can keep the volatility of their commodity portfolio down to 15-16%, he adds, which is “pretty close to equity indices historically”.

Credit Suisse manages $5.3 billion in commodity assets globally, across three strategies: its enhanced-index strategy (launched in 1994), active strategy (Access, launched this year) and Gains (which started up last year and trades based on information provided by physical commodity trader Glencore, with which Credit Suisse has a joint venture). The three products are listed here in rising order of their target risk and alpha.

The team invests in a combination of futures and over-the-counter instruments, although it only started buying commodity swaps in 2004. That’s because it started offering Ucits-compliant commodity vehicles to broaden the investor base, and such funds cannot invest in physically settled futures.

“We’ve been finding that many investors in Asia have an appetite for futures-based vehicles in the form of Sicavs,” says Karsh. “They seem to be open to any commingled fund-type vehicles with better liquidity. That’s quite favourable in comparison to many European retail investors, some of whom are quite restricted to Ucits funds.” 

He adds that the team can generate more alpha through futures-based strategies, because it’s possible to trade individual commodities and thereby generate outperformance on, say, corn or crude oil individually.

As for why commodities are particularly beneficial in times of unexpected inflation, he explains that it has to do with the way they are priced. For instance, when pricing stocks, investors use the discounted-cashflow methodology, which projects a certain amount of cashflow and earnings for the next five years and discounts that back to achieve a share price estimate.

Commodities are effectively the opposite, in that they use the futures curve to predict what will happen to the price, says Karsh. “So if crude is $78 [a barrel] today and November crude futures are trading at around $85-90, the market is taking into account potential supply/demand and also inflation to predict where the price will go,” he says.

As a result, if expectations of inflation or real inflation levels suddenly rise, the crude oil futures price will also rise, and the market will re-price its expectations accordingly -- in this case to, say, $90-95/barrel for the November futures contract. Hence, only a small rise in inflation expectations (of, say, 1%) can bring a significant profit for owners of futures contracts.