London, 5 December 2009 

Passive index-based approaches to commodity investment are being quietly dropped as returns prove disappointing. Institutional investors continue to pour money into commodities as an asset class. But they are increasingly seeking an active strategy to minimise damage done by the financing and storage costs encapsulated in the contango.

In a delightful irony, the Financial Times reports that the two academics who did most to popularise the passive approach have now joined an actively managed commodity fund ("Academic pundits join commodity fund manager").

Geert Rouwenhorst and Gary Gorton, both now professors at Yale University, co-wrote the famous 2004 paper on "Facts and Fantasies about Commodity Futures". It was instrumental in convincing pension funds and other institutional investors that commodities could be a new asset class, providing attractive long-run returns and adding useful diversification to investment portfolios.

Rouwenhorst and Gorton's paper showed investors could have earned a compound annual return of 10.7 percent from owning a fully collateralised, equal-weighted basket of 25 commodity futures between 1959 and the end of 2004.

Most of the excess return over the risk-free yield on US Treasury securities came from capturing the "risk premium" or "normal backwardation" embedded in commodity futures prices.

But as money has poured into commodity futures, and markets, especially oil, have swung into persistent contango, the index trade has become increasingly crowded and the risk premium has disappeared: a niche strategy that worked well for a small number of investors could not provide the same returns when the herd rushed to join them.

Ultimately, commodity markets are simply not large enough or deep enough to enable all institutional investors to allocate 5 or even 10 percent of their assets to them and still learn a positive return.

Disillusioned with the performance of first-generation indices such as the Goldman Sachs Commodity Index and the Dow Jones-UBS index many investors have shifted into second-generation indices that try to reduce exposure to markets and contracts worst affected by the contango, or abandoned the passive approach altogether for a system that has at least some active elements.

Rouwenhorst and Gorton have joined SummerHaven Investment Management, as a partner and senior adviser respectively. SummerHaven's other partners are mostly former employees of the commodity business at UBS. But far from the passive invest-and-forget approach popularised by the 2004 paper, SummerHaven is based on an active system. As the fund describes its strategy: "We believe it is possible to identify long-term sources of returns in commodity futures markets based on fundamental signals about the underlying physical markets. We combine our fundamental signals with disciplined trade execution to benefit from temporary price dislocations in commodity markets".

"We continuously review and periodically update our strategies based upon ongoing research and developing investment opportunities".

This sounds very much like an active management strategy, albeit one utilising "robust portfolio construction rules". It is the mixture of rules-and-discretion employed by a hedge fund, rather than the purely passive approach that was supposed to characterise the commodity indices.

When even the godfathers of the index movement join an active manager, it is time to bury the traditional indices as an inevitable way to make losses, and accept the only way to make money is to accept some element of strategic management.

Ends --