London, 11 July 2011: Reuters

In their famous 2004 paper "Facts and Fantasies about Commodity Futures" Gary Gorton and Geert Rouwenhorst outlined the case for treating commodity futures as an asset class offering a similar risk premium to equities as well as diversification benefits and protection against inflation.

But is the indexing approach to investing in commodity futures still valid? Substantial inflows of capital chasing roll returns in commodity markets have eroded the risk premium Gorton and Rouwenhorst found in the years before 2004. Rising investor participation has also tied returns more closely to those in other asset classes.

Index operators have responded by offering second and third-generation products that take a more dynamic or discretionary approach to index weightings and roll procedures in a bid to outrun the contango problem. But new products could soon become afflicted by the same crowded trade problem as their forebears.

In the end, investors may find themselves pushed towards a fully active approach via long-only discretionary funds or long/ short hedge funds. There may not be any systematic risk premium to being long a basket of commodity futures, however weighted. It may be that any premiums are a return to investors' and managers' skill in understanding fundamentals and timing the market.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now. The views expressed here are his own.

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