6.3 / 24 Accessing Commodity Investment Products

Question 1

LO 24.1: Demonstrate knowledge of the benefits and drawbacks of direct ownership of physical commodities.

Answer 1

• Discuss the benefits and drawbacks of direct ownership of various types of physical commodities

Question 2

• Discuss the benefits and drawbacks of direct ownership of various types of physical commodities.

Answer 2

• Requires transportation and proper storage which can cost a lot - Physical commodities real return has been lower than inflation historically.

Question 3

LO 24.2: Demonstrate knowledge of the benefits and drawbacks of indirect ownership of commodities

Answer 3

• Recognize the types of instruments, indices, and vehicles institutional investors may use to obtain commodity exposure through indirect investments. • Describe the characteristics of commodity index swaps. • Describe the characteristics of public commodity-based equities. • Describe the characteristics of bonds issued by commodity firms. • Describe the characteristics of commodity-based mutual funds and exchange traded funds (ETFs). • Describe the characteristics of public and private commodity partnerships. • Describe the characteristics of commodity-linked investments. • Describe the characteristics of commodity-based hedge funds. • Discuss strategies related to financing the production and trade of physical commodities.

Question 4

Indirect Commodity Investments (characteristics)

Answer 4

• involve investment in the equity or debt securities of a company that transports, produces, markets Comm’s - or investment in vehicles that actively make direct commoditiy investments, or indirect commodity investments. - preferred as most investors don’t have transportation & storage capabilities, nor the bandwidth for constantly rolling futures.

Question 5

Eight types of INdirect Investments

Answer 5

• Commodity Index Swap - Public Equities of Commodity Firms - Bonds Issued by Commodity Firms - Commodity Mutual Funds & ETFs - Commodity Partnerships - Commodity-Linked Investments - including Commodity Index-Linked NOtes, and subtype Commodity Exchange-Traded Notes (ETNs, also known as prepaid forward contracts) - Commodity Hedge Funds: Long-Only Futures Funds & Long-Only Physical Funds, and other types - Financing trade & Production of Commodities

Question 6

Commodity Index Swaps (Indirect #1)

Answer 6

• Trade fixed interest for return on a Commodity Index with a counterparty. - Plus is that you still have the underlying cash to be freely invested, - drawback is that relatively few creditworthy investors can participate, higher counterparty risk, illiquidity of the secondary market requires negotiation with counterparty to close or modify positions

Question 7

Public Equities of Commodity Firms (Indirect #2)

Answer 7

Obviously - adds risk of equity investment, business risk - higher correlation, less diversification benefit - underlying firm may hedge commodity exposure, defeating the purpose - energy and precious metals track closer to commodity prices than other commodity businesses.

Question 8

Bonds Issued by Commodity Firms (Indirect #3)

Answer 8

• High-yield issues subject to political and dfault risk tend to provide greatest correlation to commodity prices, but high-grade generally don’t track commodity prices.

Question 9

Commodity Mutual Funds and Exchange-Traded Funds (ETFs) (INdirect #4)

Answer 9

• Replicate direct investment in commodity indices - may invest in commodity firm equities, in futures, in physicals, in swaps and funds based on indexes or subindexes - may be passively or actively managed - Index based are passive but may outperform due to collaeratal - ETFs have lower fees and passively track investments - subject to basis risk if invest in futures - some may invest in equities and thus may not perform well when equities market in decline

Question 10

Master Limited Partnerships - MLPs (Indirect Commodity Investment #5

Answer 10

• pool investor capital to purchase long-term energy and mining real assets. These include extraction rights, transportation assets, refining plants, storage facilities, pipelines, and other assets. - Similar structure to REITs with the pass-through entity and distribute income without corporate tax - Most MLPs are focused on the natural resource sector - correlation to underlying commodity depends on what part of production and transport the partnership invests in - Risks include legal risk, market risk - Some are publicly listed

Question 11

Commodity-Linked Investments (Indirect #6)

Answer 11

cOMMODITY INDEX-LINKED NOTE - bond issued with a payment structure tied to a fully collateralized commodity index - loved by investors with regulatory restrictions on futures - Active secondary market, smaller investment minimums, but costs are higher than index swaps, COMMODITY EXCHANGE-TRADED NOTES - index-linked notes that are listed on a stock exchange. - They are fully collateralized, zero-coupon notes linked to the value of a commodity index or subindex (rather than futures contracts) - may have tax benefit against ETFs, due to frequent turnover of futures. - also known as PREPAID FORWARD CONTRACTS. Also can purchase FULLY MARGINED LONG-MATURITY COMMODITY FUTURES CONTRACTS - which are listed on futures exchanges, have less credit risk than ETNs, and are less expensive for retail investors. ETNs and ETFs are generally quite similar in fee levels, average returns, and invetsment strategy

Question 12

Commodity Hedge Funds (Two types of long-biased funds and others, Indirect #7)

Answer 12

• Long-only futures funds. These funds purchase and hold undervalued commodity futures contracts and are typically benchmarked to a commodity index. Positions are unhedged to maintain commodity price exposure. Advantages of this investment include professional management with expertise in rolling contracts, ability to over-or underweight commodity sectors, short lock-up periods, and relatively high liquidity and transparency. • Long-only physical funds. These funds purchase, store, and transport physical commodities to generate returns from commodity alpha (i.e., active management) and beta. These funds tend to be narrow in focus, often concentrating on a sector or specific commodity. Positions are mostly unhedged to maintain commodity price exposure. Disadvantages of this investment include long redemption notice periods and relatively low liquidity. Other commodity-focused hedge funds provide alpha, beta, or a combination of the two. Alpha is provided through cash management, long-short strategies, and investment selection. One issue with commodity hedge funds is the possibility that systematic risk will be neutralized through hedging.

Question 13

Financing Trade and Production of Commodities (Indirect #8)

Answer 13

• Private ppols organized to lend money to firms engaged in the extraction, storage, or transportation of commodities, which serve as collateral for the loans. Kilo

Question 14

LO 24.3: Demonstrate knowledge of leveraged and option-based commodity investment structures.

Answer 14

• Describe leveraged and short commodity index-based products, and apply the mathematics inherent in understanding daily performance calculations. • Describe how leveraged notes may offer leveraged exposure to commodity indices. • Discuss the characteristics of principal-guaranteed notes.

Question 15

Leveraged Commodity ETFs and ETNs

Answer 15

• because leveraged ETFs and ETNs provide daily leverage, long-term leveraged returns deviate substantially from the leveraged underlying return -the long-term return on a levered long commodity ETF can be negative even when the underlying has increased in price over the holding period. -

Question 16

Leveraged notes (Commodities)

Answer 16

index-linked notes that offer multiples of exposure to the commodity index (e.g., three times exposure would allow a $1,000 investment to control $3,000 of commodity exposure). - have embedded put option - provides limited liability. e.g.: if index declines more than 33%, note would default but be protected by put option. Put cost is included in upfront fees for investment. - provides high commodity exposure iwth only moderate up front investment.

Question 17

Principal-guaranteed notes / Principal-Protected Ntoes (Commodities)

Answer 17

participate in commodity index increases, but the principal is protected from index declines. - protection offered by these notes is subject to the creditworthiness of the issuer - CASH AND CALL STRATEGY / PARTICIPATION NOTE: In this structure, the commodity returns are earned through call options, while principal returns are earned through zero-coupon notes. - DYNAMIC STRATEGY / aka CONSTANT PROPORTION PORTFOLIO INSURANCE: In this structure, investor capital is invested in commodities and zero-coupon bonds (which forms an investment floor) based on a pre-specified proportion. As the commodities’ values change, the investment’s allocation is rebalanced. If commodities increase (decrease) in value, the commodity allocation increases (decreases).

Question 18

LO 24.4: Demonstrate knowledge of the basic concepts associated with commodity indices.

Answer 18

• Describe the characteristics of commodity indices. • Recognize the effect of a commodity index’s methodology on volatility and return levels.

Question 19

LO 24.5: Demonstrate knowledge of eight sources of commodity index returns.

Answer 19

• Describe the effect on performance of the eight sources of commodity index returns.

Question 20

Eight Sources of Commodity Index Returns

Answer 20

• Commodity beta return. • Roll return. • Spot return. • Dynamic asset allocation. • Diversification return. • Commodity weights. • Maturity •Collateral return.

Question 21

• Commodity beta return. (source of Commodity Index Returns - there are 8)

Answer 21

Returns resulting from commodity futures beta are the benchmark for assessing the performance of other strategies. They are calculated by taking the return from holding a futures contract, and then rolling it to the next active futures contract on the roll date.

Question 22

• Roll return. (source of Commodity Index Returns - there are 8)

Answer 22

Rolling futures contracts in a market with an upward (downward) sloping forward curve will result in negative (positive) roll returns. That is, backwardation will result in positive roll returns and contango will result in negative roll returns. A negative roll return indicates that the cost of carry is greater than the convenience yield for the commodity.

Question 23

• Spot return. (source of Commodity Index Returns - there are 8)

Answer 23

The spot return is calculated as the excess return less the roll return. This can also be calculated as the change in the value of futures contracts after changes in the index composition are made. Because commodity prices tend to be mean reverting over long time horizons, spot returns are not significant over the long term.

Question 24

• Dynamic asset allocation. (source of Commodity Index Returns - there are 8)

Answer 24

Dynamic asset allocation strategies such as short-term momentum strategies (i.e., overweight futures with recent gains and underweight futures with recent losses) and long-term mean-reversion strategies (i.e., increase exposure to futures trading below and decrease exposure to futures trading above their mean) can have a significant impact on returns.

Question 25

• Diversification return. (source of Commodity Index Returns - there are 8)

Answer 25

The impact of a one commodity futures contract or sector is reduced by holding a diversified portfolio of multiple commodities futures contracts that is rebalanced regularly. This also results in lower portfolio volatility. Given the fact that many commodities have low correlations with each other, a sizeable diversification return can be earned by a well-diversified commodity index that is regularly rebalanced.

Question 26

• Maturity. (source of Commodity Index Returns - there are 8)

Answer 26

Roll returns, total returns, and risk-adjusted returns (e.g., Sharpe ratios) will increase while volatility will decrease as the maturities of futures contracts in the index increases. However, longer maturities may not impact spot returns and liquidity will be less predictable. Thus, a quick liquidation may not be possible.

Question 27

•Collateral return. (source of Commodity Index Returns - there are 8)

Answer 27

Total return indices include the risk-free (e.g., T-bill) return earned on collateral (i.e., the total value of futures contract

Question 28

LO 24.6: Demonstrate knowledge of the factors to be considered in designing commodity indices.

Answer 28

• Describe the characteristics of value-based commodity indices and quantity-based commodity indices. • Describe the characteristics of total return indices and excess return indices. • Describe the characteristics of the two types of roll methodology a commodity index may employ. • Discuss considerations involved in the choice of weighting methodology. • Describe the characteristics of first generation commodity indices.

Question 29

How to Weight Commodity INdexes

Answer 29

• Value-based index. This uses fixed weights for the value of futures contracts; therefore, the number of contracts for a given commodity will change as the index is rebalanced to maintain the relative value weight of each commodity. • Quantity-based index. This uses a fixed number of contracts for each commodity; therefore, the relative value weight of each commodity will fluctuate over time.

Question 30

Total Return vs. Excess Return Commodity Index

Answer 30

• Total return index. This tracks the performance of a fully collateralized (i.e., the value of the futures is backed by risk-free assets) portfolio of commodity futures contracts. Thus, the return of the index includes the risk-free asset return. • Excess return index. This tracks the performance of a portfolio of commodity futures contracts in excess of the risk-free asset return. Thus, the collateral return is not included in an excess return index.

Question 31

Rolling Scheme - 2 parts

Answer 31

(Commodity index approach for rolling futures) 1. Position on the forward curve. This refers to the selection of the contract maturity and the specified holding period (e.g., XYZ index will use three-month contracts that are rolled one month before expiration). Compared to older commodity indices, newer indices tend to have longer holding periods and hold positions that have longer maturities. 2. Roll procedure. This stipulates how contracts will be rolled over. For example, some older indices roll over all contracts in a period of a few business days each month while some newer indices continually roll contracts. Because roll procedures for each index are published and trade volumes can be substantial, indices that need to roll over many contracts in a few days can be negatively impacted by other market participants.

Question 32

What is thought to be the largest driver of index returns for Commodites

Answer 32

weighting methodology: Each commodity index has unique criteria regarding the number of commodities, maximum and minimum commodity and sector weights, and rebalancing frequency. Common variables used to determine weights include liquidity, open interest, and world production.

Question 33

First-generation commodity indices (and examples of)

Answer 33

the first investable commodity futures indices created. S&P GSCI (STANDARD AND POOR’S GOLDMAN SACHS COMMODITY INDEX): -created 1991 - Global production-weighted on average of last five years output quntities. 19 total commodity types - Rolls from front to next contract, one month before delivery, between 5th and 9th BD; rebalance annually - Average maturity of < 2 months, shortest of all indices BCOM (BLOOMBERG COMMODITY INDEX) - created 1998 - formerly Dow Jones-UBS Commodity Index - Quantity based index, limits individual commodities to 15%, individual sectors to 33%, and a commodity combined with its processed goods to 25% of the index; 22 commodity types included; liquidity and production determine commodity weights (liquidity has twice as much influence); - Rolls from front to the next contract one month before delivery between the fifth and ninth business day - average maturity less than 2 months, longer for engergy and metals

Question 34

pre-roll strategies (Commodities indices)

Answer 34

may be able to earn alpha. In this strategy, an investor would roll their contracts several days before an index was scheduled to roll its contracts.

Question 35

LO 24.7: Demonstrate knowledge of performance enhancements provided by second-generation and third-generation commodity indices.

Answer 35

• Describe the difficulties encountered with validating the performance improvements resulting from second-generation and third-generation commodity index enhancements. • Describe the roll techniques associated with second-generation enhanced commodity indices. • Describe the roll techniques associated with third-generation enhanced commodity indices.

Question 36

Second-Generation Enhanced Commodity Indices

Answer 36

Example: Merrill Lynch Commodity Index eXtra (MLCX). - The MLCX rolls from the next to second-next contract from the first to the 15th business day of the roll month. - The MLCX has an average contract maturity one month longer than the BCOM and six weeks longer than the S&P GSCI. Overall: attempt to improve index performance through two primary methods: expanding the period over which contracts are rolled (e.g., spreading the roll period across the forward curve) and investing in contracts that are on a different portion of the forward curve. Roll Techniques: - Moving contracts to further location on forward curve - Use implied roll technqiue, which allows index to select contract within given maturity range with highest roll yield - enhanced roll techniques that reduce need for rolling by using longer term contracts, holding them near the expiration date. Can lessen impact of Contangoed Markets - Constant expiration techniaues that rely on small roll each day

Question 37

Third-Generation Enhanced Commodity Indice

Answer 37

use more active contract and weighting selection than the previous generations of indices. - criteria for composition: momentum, term structure, market-neutral positions, and rule-based approaches that incorporate technical and fundamental analysis. - CYD Long-Short TR Index is an example, takes short positions in contangoed commodities, equal wieght of long positions in backwardated commodities.

Question 38

LO 24.8: Demonstrate knowledge of commodity index return calculations.

Answer 38

• Discuss four factors that influence returns on commodity indices, and their effects on return attribution. • Describe the four measures of return attribution (i.e., spot return, excess return, total return, and realized roll return) that are typically published by commodity index providers. • Calculate returns for a given commodity index.

Question 39

four factors that influence returns on commodity indices

Answer 39

• Collateral. Differences in collateral investments can lead to differences in collateral returns. • Entry points. The timing of the rollover into new contracts influences returns. • Exit points. The exit timing from current contracts influences returns. • Weights. Commodity indices use different weighting schemes, which alters returns.

Question 40

four measures of return attribution that are typically published by commodity index providers.

Answer 40

1. Excess return. Percentage change in the market value of futures contracts before adjustments are made for index changes. 2. Spot return. Percentage change in the market value of futures contracts after adjustments are made for index changes. 3. Realized roll return. Equals the excess return less the spot return. 4. Total return. Equals the risk-free (i.e., collateral) return plus the excess return. When no index changes, excess return and spot return are equal, roll return is 0

Question 41

Spot Index & Spot Return Calculation

Answer 41

Question 42

Excess Return Index & Excess Return Formulas

Answer 42

Question 43

Total Return Index & Total Return Formula

Answer 43

Question 44

Roll Return Formula

Answer 44

roll return = excess return - spot return