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Alpha strategies involve picking up some component of a commodity or stock index that could outperform the index itself but could generate higher tracking error. In this case, the returns can be positive or negative. ..

07 Nov 2013

By Sreekumar Raghavan
Successful investing in any market requires a strategy but commodities have generally provided negative returns this year and hence investors could be worried on what strategy to take. But before moving into a discussion of strategy options before traders and investors,let us look at the global economic scenario as outlined by Standard Chartered Bank in its report on Supercycles.

Stanchart believes that the third super cycle which began in 2000 is still intact and it is being driven by growth in emerging market economies. The first super cycle lasted from 1870-1913, the second one from 1946-73 and the world experienced slower growth in 1974-2000 due to Oil crisis and several crises that hit developing nations.

Stan Chart believes that the commodity boom is over and commodity exporting countries are going to face rough weather on fall in prices. However, commodity prices could firm up in the next few years as global growth picks up but massive rise in prices seen in 2000-08 is unlikely to be repeated. However, a postive aspect of bearish oil prices could be lower inflation and hence the potential for better economic growth worldwide.Overall, a more stable trend for commodity prices is good for Asia, the main driver of the super cycle.

Barclays is also bearish in its view on commodities as it expects subdued tone to prevail after some postive trends seen in Q3, 2013 on short covering, supply disruptions in metals and energy and positive China data.

Change in strategy
If you have been following a passive benchmark related returns strategy which was quite useful till now, it is better to change track and go to alpha strategies, according to Barclays. A passive long-only benchmark returns won't work now as market dynamics has changed, it said.

Alpha strategies involve picking up some component of a commodity or stock index that could outperform the index itself but could generate higher tracking error. In this case, the returns can be positive or negative. If the investor were to follow the passive strategy, the returns will track an index but will have lower tracking error. It may not  generally create a positive alpha (returns).

However, if a passive beta strategy is combined with a smart beta strategy- you have the best of both worlds- moderate risk and returns which could be positive or negative depending on market volatility. In traditional beta strategy for equity markets, funds track equities based on price and market capitalisation while in a smart beta strategy other factors such as dividend payouts, profits and other parameters are also considered.

When you transform this into commodities-- you could have investment based on price movements and returns alone (traditional beta), or think of investments based on trading volumes, open interest, demand growth in industry and other parameters.

Barclays notes that there is a mildy negative relationship between price declines and investment inflows in individual commodity markets. Although in an index, investment inflows match the returns generated by the commodities in the index.

"Natural gas in particular stands out as having the biggest increase in its index positions of any commodity, as well as the largest price fall since 2007. At the other extreme are markets such as feeder cattle, where futures prices are up 57% compared with their end-2007 level, but index holdings have fallen 13% over the same period.

"The explanation for this phenomenon is easy to understand: to maintain a consistent set of value-based portfolio weights of different commodities over time, investors need to buy more commodities whose prices fall and sell those whose prices rise."

Moreover, commodities in a portfolio may be in contango position or in backwardation both of which requires different strategies from investment point of view. In a contango situation, farther dated securities or commodity futures are priced higher than near month or spot month prices while in backwardation near month prices are higher compared to farther month.

Most of these strategies are useful only for large institutional investors but an awareness of these could also help smaller investors to get a better perspective on behavior of markets.

The key take aways from Stanchart report:
-Global growth to pick up in 2014-17 -2000-30 average 3.5% (1973-2000-3%)
-China growth to average 7% for 2013-20, 5.3% for 2021-30
-Emerging countries share of global economy to rise to 63% by 2030
-World trade to quadruple to US$75 tn by 2030
-Emerging-country financial markets to expand rapidly- led by China and India.
-Emerging countries to achieve high catch-up growth rates, even though some, like China will slow further over time while others, such as India, Indonesia and Brazil, need significant reforms to realise the potential

(The author is Managing Editor/Chief Strategist at Commodity Online Group - a keen observer of market eccentricities and trying to make sense of them)

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