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A class of investors who have put tens of billions of dollars into commodities over the past few years does not care whether the prices of oil, wheat, cattle and the rest go up or down.
Risk premia investing, a strategy borrowed from equities markets that weighs factors other than price, has caused a boom in trading volumes on exchanges and resuscitated revenue for banks bleary from a sluggish decade in their commodities divisions.
Banks such as Bank of America Merrill Lynch, Citigroup and Macquarie are among those dealing derivatives linked to specialised risk premia benchmarks, executives say. Fund houses such as Pimco are also building their presence.
Risk premia strategies have attracted about $20bn to commodities markets over the past two years, says a senior commodities executive at a Wall Street bank involved in the trade. By comparison, commodities hedge funds have received $13bn in net inflows since 2016, according to eVestment. A fund manager using the strategy estimates that assets in commodity risk premia have increased 15-30 per cent in the past year.
“The majority of [investor] interest is in risk premia,” the commodities executive said. “The fees on simple vanilla index products have gone down to where it is uneconomic for banks to do the business.” He estimates that ultimately $60bn-$80bn would go into this strategy.
Instead of trying to predict whether commodities prices will rise or fall, risk premia investors systematically place bets based on so-called factors such as momentum, volatility and the pattern of prices for future delivery.
This stands in contrast to traditional commodities investing, which involves tracking an index such as the S&P GSCI or placing money with hedge fund managers claiming expert knowledge of the commodities they trade.
Both standard index products and many commodities hedge funds disappointed investors. Indices were hammered by the recent raw materials price rout. For several reasons, not least high fees, the average hedge fund was lacklustre.
Risk premia attempts to isolate the factors responsible for outperformance and feed them into an algorithm that selects which commodities to buy or sell. In theory they are more transparent and cheaper than a hedge fund and at least somewhat insulated from indices’ pitfalls.
The strategies differ from “enhanced” strategies, an earlier innovation built to deal with flaws in commodity index investing. Enhanced strategies hold bullish, or long, positions. Risk premia strategies might instead have long and short positions.
“Given the decline in commodities and feedback from investors, there was a lot more openness to consider other weighting schemes and approaches,” said Nic Johnson, a Pimco commodities portfolio manager. Pimco began managing long-only risk premia commodity products just over a year ago and is exploring a new commodity risk premia fund that could go long or short.
Evidence of the rise of risk premia strategies can be seen in the number of “spreading” positions, or offsetting long and short contracts held by individual traders.
Money managers’ spreading positions in the two main crude oil contracts recently surpassed 1bn barrels equivalent, one-third higher than a year ago, according to commitments of traders reports on futures and options markets. A Citigroup note last week called out “increased dealer marketing and inflows into risk premia energy products” as positions shifted in oil markets.
“The record level of spreading positions in the crude oil market is indicative of these strategies becoming a larger part of oil price moves,” said Aakash Doshi, a Citigroup analyst.
One simple risk premia strategy follows momentum: in a basket of commodity futures, the investor buys the ones that have performed better in the past year and shorts those that have done worse, based on the belief that markets digest new information gradually.
Another might involve liquidity: by purchasing a corn contract for delivery next December and hedging it with the more actively traded spot month contract, a risk premia fund could be paid a premium for its willingness to own a thinly traded contract.
A third might involve buying commodities where the spot price is highest relative to futures. This tends to be a bullish signal, since it reflects low inventories, and the strategy has the advantage of minimising the cost of rolling over futures contracts — a common problem with commodity index investing.
Some products combine these strategies in a single basket, which banks in turn package as a swap derivative sold to pension funds and other institutions. The bespoke nature of the products boosts fees for banks.
Risk premia strategies do not rely on counting barrels or bushels, having privileged contacts among physical traders and processors, or keeping up with geopolitical events — the stock in trade of traditional commodities funds. To the extent that physical statistics such as oil inventories data are used, they are plugged into models already guided by other signals.
Matt Schwab has traded for years at Goldman Sachs, long a commodities powerhouse. In a previous role he visited sites where commodities making up the GSCI index are produced, including vast cattle feeding pens. Now he is a leader of the alternative investment strategies team at Goldman Sachs Asset Management, which employs risk premia factors in commodities and other markets.
“So I’ve been to a feedlot,” Mr Schwab said. “It’s interesting, but what drives our philosophy is trying to understand the key drivers of returns and quantify those and systematise those. Everything we do is done in a quantitative fashion.”