A class of investors who have invested tens of billions of dollars in commodities over the past few years don’t care whether the prices of oil, wheat, livestock, and the like are going up or down.
Investing with risk premiums, a strategy borrowed from the equity markets that weighs on factors other than price, has caused a boom in trading volumes on the exchanges and revived the income of banks after a gloomy decade in their divisions of raw materials.
Banks such as Bank of America Merrill Lynch, Citigroup and Macquarie are among those who trade derivatives linked to benchmarks specializing in risk premiums, according to executives. Fund houses such as Pimco are also strengthening their presence.
Risk premium strategies have attracted around $ 20 billion in commodities markets over the past two years, says a senior commodities executive at a Wall Street bank involved in trading. By comparison, commodity hedge funds have received $ 13 billion in net inflows since 2016, according to eVestment. A fund manager using the strategy estimates that commodity risk premium assets have increased by 15-30% over the past year.
“The majority of [investor] the interest is in risk premiums, ”said the head of commodities. “The fees on simple vanilla index products have come down to the point where it is not profitable for banks to do business.” He estimates that over time, $ 60 billion to $ 80 billion would go into this strategy.
Instead of trying to predict whether commodity prices will rise or fall, risk premium investors routinely place bets based on so-called factors such as momentum, volatility, and the price pattern for a price. future delivery.
This contrasts with traditional investing in commodities, which involves following an index such as the S&P GSCI or placing money with hedge fund managers who claim in-depth knowledge of the commodities they trade.
Standard index products and many commodity hedge funds disappointed investors. The indices have been hammered by the recent collapse in commodity prices. For several reasons, including high fees, the average hedge fund was lackluster.
Risk premia attempt to isolate the factors responsible for outperformance and feed them into an algorithm that selects which commodities to buy or sell. In theory, they are more transparent and cheaper than a hedge fund and at least somewhat insulated from index traps.
The strategies differ from “improved” strategies, an earlier innovation designed to remedy the flaws of investing in commodity indices. Improved strategies hold bullish or long positions. Rather, risk premium strategies could have long and short positions.
“Given the decline in commodities and the feedback from investors, there was a lot more openness to consider other weighting schemes and approaches,” said Nic Johnson, Pimco’s commodities portfolio manager. Pimco started managing long-only risk premium products a little over a year ago and is exploring a new commodity risk premium fund that could be long or short.
Evidence of increasing risk premium strategies can be seen in the number of “spread” positions, or offsetting long and short contracts held by individual traders.
The spread positions of fund managers in the two main crude oil contracts recently exceeded the equivalent of a billion barrels, a third more than a year ago, according to the commitments of traders reports on futures and options markets. A Citigroup memo last week called “an increase in dealer marketing and entry into risk premium energy products” as positions shifted in oil markets.
“The record level of spread of positions in the crude oil market indicates that these strategies are becoming a larger part of oil price movements,” said Aakash Doshi, analyst at Citigroup.
A simple risk premium strategy follows momentum: in a basket of commodity futures, the investor buys those that have performed better in the past year and short sells those that have done less well, based on the belief that markets gradually digest new information.
Another might involve liquidity: by buying a corn contract for delivery next December and hedging it with the more actively traded spot month contract, a risk premium fund could receive a premium for its willingness to own a contract. low negotiation.
A third could involve the purchase of commodities that have the highest spot price compared to futures contracts. This tends to be a bullish signal because it reflects low stocks, and the strategy has the advantage of minimizing the cost of rolling forward contracts – a common problem with investing in commodity indices.
Some products combine these strategies into a single basket, which banks in turn package as a swap derivative sold to pension funds and other institutions. The bespoke nature of the products increases costs for banks.
Risk premium strategies do not rely on barrel or bushel counting, privileged contacts between physical traders and processors, or tracking geopolitical events – the stock in trading of traditional commodity funds. To the extent that physical statistics such as oil inventory data are used, they are plugged into models already guided by other signals.
Matt Schwab traded for years at Goldman Sachs, long a commodities powerhouse. In a previous role, he visited sites where the products making up the GSCI index are produced, including large feed pens. Today, he leads the Alternative Investment Strategies team at Goldman Sachs Asset Management, which uses risk premium factors in commodities and other markets.
“So I went to a feedlot,” Schwab said. “It’s interesting, but what drives our philosophy is to try to understand the main factors of performance, to quantify them and to systematize them. Everything we do is done quantitatively.