Applying Alternative Beta Strategies to Commodities

Research has found that combining risk-based and factor-based alternative beta strategies in commodities allocation could improve returns and reduce risks.

(January 2, 2014) — Using alternative beta strategies in commodities allocation could deliver higher returns and lower risk than passive long-only strategies, according to research.

The authors of “Alternative Beta Strategies in Commodities”—Daniel Ung and Xiaoweig Kang of S&P Dow Jones Indices—found both risk-based and factor-based alternative beta indices in commodities have helped reduce risks and volatility.

“Both risk-based strategies have succeeded in lowering risk,” the research said. “It is also apparent from the results that the risk-weight strategy was far superior to the minimum-variance when seen through the prism of risk and return trade-off.”

Ung and Kang said that with the high correlation between commodity prices and volatility, “merely targeting the lowest level of volatility appears counter-intuitive, and a more satisfactory approach would be to target risk reduction by assigning a risk budget across different commodities and sectors.”

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The paper concluded that in applying a factor-based approach on commodities to improve returns from potential risk premia associated with systematic factors, investors should look at value, curve, momentum, and liquidity.

Value strategies work to generate excess returns purchasing undervalued commodities with expectations of rising prices. S&P Dow Jones Indices’ research showed that value strategies performed well—achieving a higher Sharpe ratio than their benchmarks—but the authors said there would always be a possibility of periods of underperformance.

Curve strategies aim to alleviate the negative impact of the “contango” period of negative carry by pursuing contracts with longer maturity.

“These strategies aim to capture a risk premium for taking greater price uncertainty associated with futures contracts on the long end of the curve,” the study said.

The momentum strategies target the tenacity of commodity returns—“which are believed to drive from psychological biases exhibited by investors and behavior displayed by industrial market participants,” Ung and Kang found.

The research said momentum strategies could offer downside protection during sharp market corrections and still continue to provide upside participation during bull markets.

And lastly, liquidity strategies look to assess various lengths of the rolling period for higher returns. Though this approach would generate the smallest return—compared to value, curve, and momentum—“it is nonetheless unique to the commodity markets,” the paper found.

The most effective strategy, Ung and Kang said, was to combine all sources of risk premia to diversify risk.

“It should be borne in mind that alternative beta strategies often take substantial active risks, which are largely driven by factor exposures,” the authors said. “However, as these risk factors have a low correlation with each other, it may be sensible to combine them in order to improve return and reduce risk.”

(January 2, 2014) — GIC, one of the two sovereign wealth funds of Singapore, was has been named as the one of the biggest investors in private equity for 2013.

According to Indian investment research platform VCCircle’s calculations, GIC was among the top investors both in terms of the amount of invested, as well as the number of transactions sealed this year.

Investing more than $650 million in 2013, GIC devoted significant amounts of money to Indian private equity in particular over the past 12 months, ramping up its activity after opening an office in the region in 2011.

GIC was also noted for making contrarian bets on sectors like power and real estate, which have been out of favour with the broader investment market.

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But GIC’s favourite sector over last year has been India’s real estate: it partnered with Blackstone Real Estate Partners to acquire an IT park in Bangalore and also tied up with private equity powerhouse KKR to set up a real estate-focused non-banking financial company. It also partnered Singapore’s developer-investor Ascendas to invest S$600 million in Indian property.

GIC’s largest deal of the year was also agreed in India, acquiring 2.6% of private sector lender Kotak Mahindra Bank for $239 million, in what would be its single-largest deal during the year.

According to its own figures, approximately 28% of GIC’s assets are invested in Asia, up from 23% in 2008. This makes it the second largest geographical area in terms of investment, behind the Americas, which makes up 44% of the portfolio. Europe has seen the most drastic reduction, from 35% in 2008 to 25% in 2013.

The sovereign wealth fund appointed a new CIO in January 2013, Lim Chow Kiat, who spoke openly about wanting to take the fund in a new direction.

Having initially been created using the endowment model, Kiat introduced a new framework designed to define GIC’s risk and return drivers, its long-term investment objectives, and the responsibilities of the GIC board and management more clearly.

The revised policy portfolio now focuses on six core asset classes: developed market equities, emerging market equities, nominal bonds and cash, inflation-linked bonds, private equity, and real estate.

These asset classes represent the key systematic or market risks, and encapsulate the bulk of the risk and return potential of the GIC portfolio, all of which is actively managed. The active portfolio allows the GIC management to execute skill-based and opportunistic strategies, including the aforementioned pushes into private equity.

The passively managed reference portfolio meanwhile, based on a balance of 65% global equity and 35% bond market indices, defines the amount of risk the government is prepared to have GIC take.

Its annual nominalised rates of return up to March 31, 2013 were 12.8% over five years, 10.3% over 10 years, and 9.3% over 25 years.