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Why Are So Many Commodity Funds Underperforming?

Fewer than half of commodity funds are beating their benchmarks since the Russian invasion.

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Editor’s note: Read the latest on how Russia's invasion of Ukraine is affecting the global economy and what it means for investors.

Commodity prices are surging, but many investors in commodity funds are seeing some of those gains left on the table.

Everything from staples like oil and wheat to metals like nickel and palladium have surged following Russia’s invasion of Ukraine. Already driven higher from sizable demand and supply challenges, the ongoing war between two critical suppliers of major commodities has wreaked havoc on these markets and sent prices soaring to record gains.

Despite that, the majority of fund managers lag their benchmarks. Of the 29 commodity mutual fund and exchange-traded funds that use the Bloomberg Commodity Index as their primary benchmark, just eight were ahead of the index’s 27.0% year-to-date gain through March 9. Only one of the six funds that uses the next most popular index, the S&P GSCI, beats that bogy. Managers have taken advantage of recent volatility to drive better results as of late, but still, less than half of managers have outperformed their benchmarks from the start of the Russian invasion on Feb. 24 through March 9.

What’s driving this underperformance? Minor differences between the funds and the index--like which futures contract they invest in--may seem trivial but have contributed to some of these differences. Factors like this, which have traditionally been a boost for the funds versus their index, have been a headwind in what's been an incredibly volatile year for the commodity marketplace.

A Wild Week for Commodities

During the week of Feb. 28, the Bloomberg Commodity Index rose 13.0%, its highest weekly gain ever. That was double its previous highest weekly gain, which occurred during the financial crisis, when it rose 6.5% the week of March 15, 2009.


The Bloomberg Commodity Subindexes show that the surge in prices happened across the commodity complex. The Bloomberg Subindexes for Energy (up 8.9%), Grains (up 18.2%), and Industrial Metals (up 13.5%) all had their highest one-week gains ever, while the Precious Metals Index’s 5.0% gain was in the top 2% of weekly performance. The Softs (which encompasses coffee, sugar, and cotton) (up 1.0%) and Livestock (down 3.9%) indexes were off on a relative basis. On an individual commodity basis, Aluminum (up 14.7%), Wheat (up 40.6%), Petroleum (up 25.8%), Heating Oil (up 30.2%), and Brent Crude (up 25.5%) all set records as well.


- source: Morningstar

Last week was the largest move upward in commodities since at least 1990, when the Bloomberg Commodity Indexes came out. This includes the 1998 emerging-markets crisis, dot-com recession, great financial crisis, and coronavirus crash, all of which had massive market impacts.

The volatility has continued this week, with the Bloomberg Commodity Index rising 4.4% through Monday and Tuesday before falling 5.1% on Wednesday. This has led to knock-on effects in the market. The London Mercantile Exchange halted all trading in nickel contracts, after a massive short squeeze led to a rally of more than 200% in the futures contracts. This led to the liquidation of the WisdomTree Nickel 3x Daily Short ETF, an ETF that attempts to mirror a highly leveraged short bet on the price of nickel. The Teucrium Wheat ETF (WEAT) stopped issuing new blocks of shares after high demand caused the fund to hit a regulatory limit of new share issuance.

The war has triggered supply uncertainty and driven this move. The swift action of the international community to isolate Russia has indeed devastated its economy, with the Russian ruble trading for more than $139 U.S. dollars on March 7 after trading below $80 as recently as Feb. 23. It’s also sowed tremendous doubt about where the next barrel of oil or bushel of wheat will come from. Below is a table of commodities in the Bloomberg Commodity Index where Russia (or in the case of wheat, Russia and Ukraine combined) accounts for more than 5% of global production.[1]

The front part of the futures curve (the positions closest to being exercised) has steepened significantly. This occurrence--called backwardation--happens when there is more demand for the asset in the near future than in the distant future. There can be multiple reasons for this, including a shortage of the commodity in the spot market, heightened ambiguity surrounding short-term supply, and technical selling pressures. All are likely at play in current markets, which UBS has called “super backwardation”.


- source: https://www.erce.energy/graph/brent-futures-curve/

How Have Fund Managers Done?

The average fund in the commodities broad basket Morningstar Category has posted a 26.1% gain for the year to date through March 9, behind the Bloomberg Commodity Index's 27.0%. Results have been better since the war began on Feb. 24; 13 strategies have topped the index’s 10.1% gain. That’s up from the initial days of the conflict; just six strategies were ahead of the index through last Friday.

There are technical reasons for this performance pattern. The Bloomberg Commodity Index tracks contracts closer to the front of the curve, which are typically the most sensitive to current events. Meanwhile, active fund managers typically diversify across multiple contracts to control risks and sometimes take advantage of relative value opportunities. Diversification across these contracts and prudent management of where and when to roll to new contracts has traditionally been a tailwind for these strategies; 15 of the 23 funds that have five-year track records and use the Bloomberg Commodity Index have topped the benchmark over the trailing five years.

Strategy design heavily influences performance, too. Most commodity strategies aim to closely track a specific index--usually the Bloomberg Commodity Index--and add value by making small tactical tilts or actively managing the collateral that backs the futures contracts. This “index-plus” approach leads to performance that closely mirrors the index, for better or worse. Index selection is important for investors in these types of funds. For example, the Bloomberg Commodity Index targets approximately 30% exposure to energy markets, while the Credit Suisse Commodity Index targets more than 50%. That has a big impact on results; the Credit Suisse index is up 31.4% for the year to date, versus just 27.0% for the Bloomberg index.

Others funds will deviate more substantially from these common indexes. For example, BlackRock Commodity Strategies (BICSX) invests half of its assets in commodities and half in natural-resources equities. Commodities have surged ahead of natural-resources equities since the war began, and the fund’s 22.6% year-to-date gain lags 89% of category peers. The use of equities in addition to commodities may provide some benefits when commodities lag, but it dilutes the effect of commodities during periods of steep price increases.

Although some investors may seek other strategies, an index-plus approach is one of the best ways to gain exposure to commodity price moves, owing to their diversified commodity exposure and relatively predictable return patterns. Morningstar only rates two commodity strategies, both of which are index-plus offerings from Pimco. We checked in with the lead manager of those strategies, as well as the lead manager on DWS’ index-plus commodity strategy, to hear how they’re positioning their portfolios.

Greg Sharenow, manager of Pimco Commodity Real Return (PCRIX) and Pimco CommoditiesPLUS (PCLIX) strategies, each of which have Morningstar Analyst Ratings of Silver, says the backwardation in most major commodity markets is a strong signal of future returns. The team has a tactical overweight to longer-dated wheat contracts, based on its view that exports from Russia and Ukraine as well as the 2022 crop season will be challenged. Uncertainties are reflected in the extreme moves at the front part of the curve, but contracts further out haven’t moved as much, which is where the team is positioned. It also has an overweight to California Carbon Credits, an off-benchmark position the team frequently trades. Spillover effects from Europe’s carbon markets’ selloff has led to a steep decline in the California markets, which the team feels is driven by technical factors and not grounded in fundamentals. Although each fund trails its respective benchmark for the year to date, each has outperformed since the Russian invasion began, and each is in the top quartile of category peers over the trailing five years.

Bronze-rated DWS RREEF Real Assets (AAAZX) team member Darwei Kung, who also runs the uncovered DWS Enhanced Commodity Strategy (SKIRX), sees uncertainty remaining at the front of the futures curve over the near term, with a potential Iran deal looming over energy markets. For now, he and the team are overweight oil and underweight natural gas, as they see U.S. production able to alleviate prices in the gas market. They also have an industrial-metals overweight versus precious metals, with Kung citing increased China demand in addition to the current geopolitical headwinds.

Although we’ve written in the past that commodities aren’t essential in an investor's portfolio, some investors still find they serve a role as a diversifier in times like these. These strategies can undergo severe bouts of underperformance but can provide much-needed diversification in commodity shocks.


[1]Source: USGS, FAO, BP

https://pubs.er.usgs.gov/publication/mcs2022

https://www.fao.org/faostat/en/#rankings/countries_by_commodity

https://www.bp.com/en/global/corporate/energy-economics/statistical-review-of-world-energy.html


Bobby Blue does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.