Paul Justice: Hi. I'm Paul Justice, director of exchange-traded fund research in North America from Morningstar. I'm coming to you live from the ETF Invest Conference in Chicago. Today, I have the pleasure of being joined by Geert Rouwenhorst, Yale professor and originator of one of our favorite commodity funds in the market today, the United States Commodity Index ETF, ticker USCI. Geert thank you so much for joining me.
K. Geert Rouwenhorst: Thanks, Paul, for having me.
Justice: So much of your research has been influential on the way that people approach the commodities' market. Your paper back in 2004 with Gary Gorton was really influential in driving people to the asset-allocation and total-return benefits of commodities. Could you talk a little bit about that research and where you identified sources of returns for commodity markets?
Rouwenhorst: Right. So prior to the paper, Gary and I asked a question, what do we actually know about the merits of going passively long in commodity futures? And the problem was there was no good data available to analyze the returns on those investments. Typically, we have very good data on stocks and bonds. We had none on commodities. So the simple thing we try to do is put together a long time series going back to 1960 and analyze the performance of this asset class.
Surprisingly, you know a commodity index consists typically of two things. It's a collateral return, typically T-bills or some fixed-income instrument, and then that's overlaid by a long position in futures. And people ask, is there any return that you can get from the futures component of that portfolio? And it turned out that during that 50-year-period that we looked at, there risk premium that you would get from the futures component was about 5% annualized, which is actually the same risk premium that people generally associate with in investing in the stock market. So it was quite a big surprise.
Justice: Yeah. The great thing about that was you're getting a return that was both positive on a real adjusted basis and had a very low correlation with the other asset classes that you had in the portfolio.
Rouwenhorst: Right. So that is one of the things that made it of course very attractive for large institutional portfolios because it was a means to diversify sort of the traditional asset classes such as stocks and bonds. Now, more recently what we've seen is that while the correlations between commodities and bonds have remained stable and low, pretty close to zero, the commodity correlations with equities have actually been creeping up relative to the long-term average that we have been documenting in our research.
There could be two reasons for that. We've been going through a time of crises somewhat, and if you look back historically, correlations have been higher during previous crises as well. Another explanation may have to do with the fact that there's more interest in this asset class, and people trade in and out into commodities in the same way as they do in the equity markets based on the risk appetite of the moment.
Justice: Certainly, the investor interest in this space, probably because the accessibility of commodities, has greatly increased partially because of ETFs and some other investments, but that certainly has had an influence on the performance of just a simple passive long-only commodity funds notably between 2007 and 2010. But you advanced some of the product knowledge by focusing on the real sources of return, not just on the spot performance of the commodity, but optimizing the other factors. Could you talk about those?
Rouwenhorst: Yes, I think the hard part about getting your arms around commodity futures products is that it has to do with futures and most of the intuition that investors have is about spot markets. So people might see that the oil prices go up by 10%, and they see their ETF not going up by 10% and say "What's wrong with the my ETF?" I think the biggest mistake that investors sometimes make in this evaluation is that just looking at spot returns is actually not a fair way to look at a commodities investment, because as in any investment what you have to do is you have to look at the performance net of all the holding costs of the asset.
In commodities, especially spot commodities, that holding cost can be pretty large. The storage cost of oil can run anywhere between 5% and 10% per year, what an investor in the spot market would have to subtract from his return. Now, as a futures investor, you don't completely avoid those costs, but it goes under a different name. It's not called storage cost; it's called the negative roll yield.
So, during periods of low economic activity when inventories are high and we need to store a lot of those commodities, those are times when the return on commodity futures as well as commodity spots are hurt by the storage costs or negative roll yield. So, one of the things that we've tried to do in with the USCI is to try to concentrate on commodities where actually inventories are low and you don't really suffer this negative roll yield. Another way of saying that is that you avoid sort of the storage costs that are associated with commodities. And research has shown that there is a very simple way of doing this, and its actually just looking at sort of the backwardation that commodities are in. By selectively moving your portfolio around toward the most backwardated commodities, you can see that actually helps your return in the long run.
Justice: So, you're not only focusing on the passive nature, you've added into couple of fundamental factors to focus on optimizing the return within the strategy, that is focusing on some momentum factors and focusing on the storage factor to make sure the economic rents accrue to the investor.
Rouwenhorst: Absolutely. It's sort of been a novel thing; it's been a challenge to sort of bring it out. I think banks may have offered that to clients in the forms of swaps at some point in the last five years. But that's never been available to retail investors in the form of an ETF where it's a very easily investable and transparent product.
Justice: Great. Well thank you for brining us the intelligent evolution of ETFs. Thank you for joining us.
Rouwenhorst: Thanks very much, Paul.