Wealth Manager

Futures contracts come in a range of expiration dates and prices,
which creates risk and opportunity. Indeed, even a passive
strategy intent on long-term exposure to commodity futures requires
relatively frequent trading. Carrying a long position in oil
futures, for instance, obliges recurring purchases of longer-dated
contracts as replacements for the expiring ones. The associated
risk is that selling a contract that expires this month and buying
one that expires next month or next year—so called
rolling—can produce a loss or profit. It all
depends on the shape of the futures curve at the
time of rolling.

A downward sloping curve is said to be in backwardation.
That is, contracts expiring further out
in time trade at lower prices than contracts expiring
earlier. In that case, selling a March contract
and rolling into a June produces a gain—a positive
roll yield. In contrast, if the futures curve is
in contango, or upward sloping, contracts expiring
further out in time cost more and so rolling
into longer-dated contracts loses money—negative
roll yield.

The potential for losing money from negative
roll yield adds to the fundamental risk tied to a commodity’s
outlook for its spot, or cash price. Consider that the spot, or near
term-contract price for crude oil has been in a bull market for five
years. Nonetheless, it’s been possible for long-only traders to
lose money in oil futures in recent years because of contango’s
frequent presence.

Another complication is the fact that the standard investable
commodity indices make little or no effort to minimize the fallout
from the changing shape of futures curves. In fact, roll returns
towered over spot returns as factors driving Goldman Sachs Commodity
Index’s (GSCI) excess returns (performance over T-bills)
during the period from 1982 to 2004, according to a recent paper
in Financial Analysts Journal (“The Strategic Value of Commodities,”
March/April 2006). The lesson: commodity investors ignore the
roll return at their peril.

The caveat inspired Kochis Fitz to search for a better investable
commodity index for its asset allocation strategies. After
16 months of research, the San Francisco wealth
manager designed (in partnership with Goldman
Sachs) the S&P GSCI Enhanced Commodity
Total Return Strategy Index, which Goldman
launched in July as an exchange traded note
(NYSE: GSC). Although the new index underlying
the ETN holds the same commodities in the
same weights as per the standard GSCI, contract
rolling is managed with an eye on exploiting opportunity
—or at least, minimizing losses. At the
same time, the enhanced rules are said to be designed
and applied in a systematic, transparent
manner that befits an index fund.

Economist Jason Thomas, chief investment officer
at Kochis Fitz, says that its modified GSCI
dramatically outperformed its standard counterpart by an annualized
900 basis points for the 10 years through July 31, 2007. It’s any
one’s guess if that back-tested premium will continue, although
Kochis Fitz expects that the new benchmark will deliver a durable
premium of some degree over the standard GSCI. The firm has
put real money behind the bet on its modified commodity index
to the tune of an initial investment of $70 million. Meanwhile,
Kochis Fitz moved clients—who have an average portfolio of $5
million—out of another ETN that tracked the standard GSCI.

It’s too soon to say if others will follow Kochis Fitz’s example,
but the opportunity is huge. The standard GSCI commands the
lion’s share of assets among investable commodity indices with
$60 billion tracking the benchmark globally as of this past May,
according to Standard & Poor’s, which acquired the index from
Goldman earlier this year.

For some details on Kochis Fitz’s embrace of the enhanced
GSCI, we recently talked with Thomas, who previously worked
as chief economist for the fund-of-funds business at Wilshire
Associates and in the private wealth management group at Goldman
Sachs.

Q: Why did you design an alternative to the standard GSCI?

A: I decided in early 2006 that the existing [commodity index] products
weren’t meeting our needs, which are, of course, the needs
of our clients. Initially, we chose the Goldman Sachs Commodity
Index. At the time—early 2006—the problem was that the oil
market was in steep contango and we were losing money every
month with the roll. We spoke to a number of different firms
about various strategies. Commodity trading advisors and some
hedge funds were making a lot of money from the situation, and
I thought that we’ve got to find a way to incorporate some of
those strategies into our portfolios.

We finally hit on a partnership with Goldman Sachs, which
uses a number of interesting strategies for its commodities’ trading
that modify the commodity rolls. In effect, Goldman had
a menu of various strategies. Ours was an interaction with the
institutional group at Goldman—the firm’s internal commodity
trading desk where traders are intimately involved with the commodities
markets. We worked with them on a number of strategies
and hit on one that we thought was the best.

We were also adamant that the strategy needed to be in an
exchange traded note [ETN] and not a mutual fund, ETF or a private-
placement structured product.

Q: Why an ETN?

A: ETNs allow the most flexibility for Goldman to manage its liabilities,
which is providing the return of the underlying index. That, we
think, results in a lower fee. Also, the strategy is much more tax-efficient
[for investors] in an ETN rather than an ETF or mutual fund.

Q: What exactly are investors buying with the new ETN?

A: They’re buying the return of a basket of commodities that’s the
same as the standard GSCI in terms of composition and weights.
The difference is the roll management.

There are three roll modifications: The first one, which adds
the most value, takes advantage of seasonality. There’s a growing
cycle for corn, for instance. For cattle, there’s a calving cycle. For
heating oil, there’s big demand in the winter, low demand in the
summer. The standard GSCI pays no attention to the fact that
commodities go through cycles. But seasonality factors cause
predictable changes in the futures curve throughout the course
of the year. If you roll every month, you make a lot of money at
certain times of the year, and you expect to lose money at other
times of the year. You hope that it nets out to a positive.

Q: Can you give us an example of how managing seasonality can
work to the new index’s advantage?

A: Take heating oil, where you make a lot of money in the winter,
and you lose a lot of money in the summer because of negative
roll yield. Instead of doing that, our index rolls from January to
the next January contract; we jump past the period in the year
when we’re losing money.

For other commodities, the timing of the roll varies, depending
on the seasonal pattern, which exists for structural reasons.
Commodities generally are difficult to store and transport, and
so it’s expensive to do so. Consider heating oil again, where all
the demand comes in a short period of the year. It’s a systematic
trend, and for a good reason. An arbitrage that tries to exploit
the trend would be to buy heating oil in the summer and store it.
But that’s difficult and expensive, and so the seasonal pattern is
difficult to arbitrage away.

Q: Seasonality is one modification. What’s the second?

A: The so-called dynamic roll for oil, which added a lot of value in
the backtest. The methodology for crude oil looks at the shape of
the futures curve every month. A curve that’s in backwardation
has a positive yield, and so we earn money every time we roll. In
those cases, there’s no difference relative to the standard GSCI.
But we roll less frequently when the oil futures curve is in contango--
meaning that it’s upward sloping so that contracts expiring
further out are more expensive. That mitigates the negative roll
yield. It’s still negative if the curve is in contango, but it’s less so.

Q: So, the second modification applies only to crude oil, and the
rules vary, depending on the shape of the oil futures curve?

A: Right, because there’s no predictable, discernable seasonality to
crude oil.

Q: What’s the third modification?

A: Rolling at different times of the month. The standard GSCI rolls
all the contracts, starting on the fifth through the ninth of every
month, into the next-nearest contract. Our index enhances
the rule by rolling earlier—the first through the fifth day of the
month. That means that we start selling before there’s selling
pressure and start buying before there’s buying pressure.

Q: In other words, you’re trying to exploit opportunities created by
pre-set buying and selling trades linked to the standard GScI?

A: Right, although this modification is the most likely among the
three to be arbitraged away. But that would first require that billions
of dollars start rolling by our methodology.

Q: Considering that the new index’s rules vary depending on the
state of the futures market at a given time, is it clear from the
prospectus how your index is managed?

A: Yes. Now you’re getting to the heart of my investment philosophy
and the reason why I wanted to launch this ETN. We could
have hired a commodity trading advisor [to manage the roll]. The
reason we didn’t is that I want commodities beta, and so I want
something that’s structural for the enhancements in the new
index. I have a very skeptical view of people’s ability to add value
through active management. We have almost no active managers
in our core client portfolios. I want something that makes sense
to me as being durable for the long run.

Q: Why should the three index modifications be durable?

A: Take natural gas, for example, which is one of the commodities
we roll based on seasonality. We roll the contracts from January
to the next January. I don’t need someone in the market to make
a mistake in order for us to outperform. Natural gas is used in the
winter and it’s expensive to transport and store, and so there’s a
structural reason why our methodology should outperform over
time versus the standard GSCI’s natural gas exposure.

Overall, the three enhancements may sound like minor tweaks,
but there’s a huge outperformance to be gained by making these
tweaks.

Q: There are other publicly traded commodity funds that manage
the roll in various ways. Why didn’t they suffice?

A: Yes, there are a few of them. But the problem with the other indices
is that they don’t give us the beta that we want. That is,
they change the weightings and the components underlying the
GSCI in a way that makes them less attractive to us for portfolio
construction.

Q: That raises the point that the GSCI is notable for its heavy energy/
crude oil weighting relative to competing indices. Why is
that bias attractive?

A: Our portfolios are heavily weighted toward equities. So, what we
own on behalf of clients is a portfolio of companies whose primary
business is taking raw materials and translating them into more
valuable outputs. It’s not an arbitrary decision to give oil the biggest
weight in the GSCI. Energy is the biggest input for our companies
and the global economy. Commodities are in our portfolio to
hedge a risk that we have no control over—an uncompensated risk
that’s not adding any value to our [equity] holdings.

We can have academic debates about what captures commodities
as an asset class. But we’re not looking at it that way. Rather,
we’re asking, Where’s our biggest risk as global equity investors?
Having a little bit of commodities in the portfolio allows you to
take more risk in areas where there’s a sustainable and rational
risk premium.

As it turns out, oil has been a fantastic return source for the
past 20 years. But we give that assumption a haircut for the future,
and so commodities for us are a low expected-return asset
class relative to equity asset classes we own.

Q: Why the low-return outlook for commodities?

A: It’s a combination of things. It’s a view based on our econometric
analysis, but it’s also recognition that there’s a financial
market component to commodity returns; there’s a speculative
component to the realized historical oil returns. There
were particular crises that generated past returns for holders
of financial instruments related to oil—returns that we
shouldn’t expect to get in the future. And the money that’s
recently been flowing into commodities will likely reduce the
expected premium. Even if there’s a Keynesian-type backwardation
premium for taking the long side of the trade in oil, the
more money that goes into the market, particularly long-term
passive index money, the lower the premium should be. But
commodities are still a fantastic addition to the portfolio and
we want it to play the role that it needs to play, and the way to
do that is primarily through oil.