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Where's the alpha?

By Jayne Jung

October 29, 2009 - Commodity index funds, currently the subject of much controversy for their perceived role in increasing both energy prices and energy price volatility, have allowed a wide range of financial investors access to energy markets.

Driven by potential gains, diversification and inflation hedging, investment has rebounded this year, but their success is threatened by both regulatory and economic uncertainties.

What is 'alpha'? In financial parlance, alpha refers to the profits generated by the prowess of a particular portfolio manager.

Beta, on the other hand, refers to market returns, or the aggregate expectations of many. Like vodka and tonic, alpha and beta are somewhat difficult to separate once they've been mixed together.

Nonetheless, investors are seeking alpha when they hand their money over to hedge funds or Commodity Trading Advisors.

They are charged more and thus have a legitimate expectation that their investments outperform standard market returns.

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Fees are often 2% of the assets under management plus a 20% performance fee. By contrast, the average fee for an index-linked swap is 0.3%. However, some 'enhanced beta' commodity index funds have recently been outperforming their active management counterparts hand-over-fist.

Commodity index funds are rules-based, in that the proportion of the index made up by different commodities is determined by mathematical formulas and not an active portfolio manager.

The funds are typically 'long only', which means that by buying into the funds, investors make money when commodity prices rise and lose money when they fall.

They are typically heavily weighted towards energy, and crude oil in particular, as opposed to metals or agriculture.

The funds' positions have to be rolled forward each month as futures contracts expire. If the market is in backwardation – prompt prices are higher than longer dated ones – the month-to-month roll will produce returns because the prompt month contract is sold at a higher price than the cost of buying the next month's. (See chart: Commodity indices have suffered )

If the opposite holds – known as 'contango' – the rolls produce losses, as has been the case this year.

To avoid the losses incurred when the market is in contango, some 'enhanced beta' indices allow investors to take short positions or to invest in other parts of the forward curve (See chart: Traditional and enhanced indices spot and roll).

Index fund resurgence

According to the latest data from Credit Suisse/Tremont, released in September, managed futures funds, which include CTAs, had negative returns of 7.10% for the year through to end-August.

By contrast, energy hedge funds that invest the majority of their assets in energy stocks, but also some futures, returned about 17.6%, according to Hedge Fund Review, a Chicago-based research firm.

Some rules-based enhanced beta indices have performed better. The UBS Bloomberg Constant Maturity Commodity Excess Return Index posted a comparable return of 20.13%.

The Merrill Lynch Commodity Index Extra rose 14.75%, while the Deutsche Bank Liquid Commodity Index-Optimum Yield did less well, returning 4.42%. Oil-based indices' performance has been particularly strong: the DBLCI Optimum Yield Crude Oil ER Index, the MLCX Crude Oil ER Index, and the UBS Bloomberg CMCI Crude Oil ER Index increased 24.46%, 12.90%, and 20.31%, respectively.

"The hedge funds that have a high correlation to beta have outperformed their benchmarks," says Gustavo Soares, a commodity strategist for Merrill Lynch, the investment banking arm of Bank of America.

"But some hedge funds claim that they can make money all of the time, which is a slightly different proposition. Those guys have had a hard time doing so in the past, especially when you compare them to enhanced indexes."

Investors have taken note. During second-quarter 2009, there was a strong resurgence in commodity index investing. Commodity index funds saw their second largest quarterly increase in assets under management ever, according to Barclays Capital.

The investment bank estimated that commodity assets under management rose $34 billion between the first and second quarter of this year, to about $209 billion.

Roughly one third of these funds flowed into energy investments, and about a fifth into agriculture, according to the report.

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