INVESTMENT BANK TRADING floors are becoming divided territories. On one side are equity sales, trading and research staff who, quietly wondering why they bother coming to work to grapple with deteriorating markets, try to salvage some of their clients’ portfolios and keep a slice of their bonuses.
On the other side you have debt teams, which have thrived recently on risk aversion, interest rate cuts and a search for yield that has also tightened credit spreads in many high-grade and high-yield sectors. Their fear is that this can’t last and that the bond market bubble will burst with a bang just as equities did in 2001.
In the middle, you have commodities teams. Trading volumes are increasing, headcount is rising, and new projects are emerging as quickly as the boffins can dream them up. Suddenly it is sexier to trade soya beans than equities or bonds.
“Banks are investing in their commodities operations because they know that the client business is out there,” says Jean-Marc Bonnefous, global head of commodity derivatives at BNP Paribas in New York. “We get a lot of phone calls about commodities these days. There is also from the bank’s point of view the benefit of having diversified revenues – the negative correlation with other assets classes makes it a desirable product to grow.”
So it is a virtuous circle: investors’ equity portfolios are suffering, and many of them are predicting a new rise in inflation. They are looking at commodities because they either want to take a punt on a rising market or balance out weak portfolios of traditional assets. Meanwhile, banks and their smooth-talking sales people want to make some revenue out of a counter-cyclical asset class.
Several firms have caught on to this, possibly hoping to replicate the success of Goldman Sachs, which dominates the market. But they should be careful, because it comes at a financial and possibly also a cultural cost.
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“If you want to be competitive, if you want to avoid being seen as an also-ran, you do have to pay up,” says Jim Hyde, a bank sector strategist at Fox-Pitt, Kelton in London. “Does your corporate culture support that? Have you got a corporate culture that accepts that different departments will have periods of super performance and pay? That is a difficult management task. Many banks have made a mess of this in the past.”
Should banks now be lavishing high pay on commodities traders?. After all, the rise in commodity prices is a result of economic cycles rather than the ingenuity of bankers.
The question for banks is how to harness these price rises and create nifty financial products from them. BNP Paribas is working to capitalize on investors’ new-found interest in commodities. Its commodities division in itself is not new – Paribas had been a prominent commodities firm since well before its merger with BNP – but the bank has consolidated its formerly separate commodities-based businesses into one unit, known as the energy, commodities, export and project division. It has plans to launch an initiative in European electricity trading and risk management later this year.
“We have seen our corporate hedging practice explode in terms of the number of customers using it,” says Bonnefous. “At the same time, there has been increasing appetite for a smaller segment of commodities derivatives, which covers exotics, indices and structured notes.”
And BNP Paribas is not alone. Deutsche Bank has also always had a large commodities business, particularly in base metals, but this has never been at the core of the firm’s global markets division. “They were a niche 14 months ago,” says Kevin Rodgers, managing director and head of commodity correlation trading at the firm. “But the group is certainly growing fast, in terms of people and profitability.”
The bank has made a senior management decision, led by Anshu Jain, to hire internally and externally to build the commodities team worldwide. Headcount now stands at around 80. Rodgers himself was transferred to the commodities division, having previously run forex options at the bank. Although the firm is reluctant to reveal the commodities division’s profitability levels, it does say that the rise in revenues is outstripping the rise in headcount.
“The faith that people had in other traditional assets has been dented,” says Rodgers. “We have had three bad years in the equity markets and now we are seeing very low bond yields. So investors are looking around at products that previously they would not have touched with a bargepole. Commodities are becoming less of a minority interest – there is more attention on how to use them.”
The primacy of hedge funds
SG is another firm that is building up its commodities presence. Having brought commodities finance and trading together in 2000, it integrated that group into its debt finance division in February 2003. This means that it is easier for the bank to offer financing and hedging to commodities-dependent corporates in one package. And it also means that the bank can offer new instruments to investors.
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“It is difficult to ignore hedge funds,” says François-Xavier Saint-Macary, co-head of commodities at the bank. “In some commodities, hedge funds really explain price movements. In base metals, for example, you can see how the players act – they are strategic clients who can move the market. I would be lying if I said that investors represented the largest part of our income from commodities. Their volumes are still lower than we see from corporates, but they are becoming interesting.”
SG has increasingly focused on commodity investors over the past two years, and especially over the past 12 months. The bank now has around 200 people working on commodities worldwide, in finance and trading.
If pessimistic analysts are right – if equity markets still have another five years or more of bad conditions ahead of them and fixed income is due to correct – then commodities could generate the same kind of bull market enthusiasm as the capital markets did in the late 1990s. And the best thing about them is that they are economically incapable of forming false rallies. “Because of the mean reversion of commodity assets, it is more difficult to have a long-lasting speculative bubble in commodities,” says Bonnefous at BNP Paribas. “The marginal cost of production will ultimately drive the price to the medium range. In the long term, that is very efficient.”
This is all very tempting to revenue-hungry banks. But it is unclear whether this search for innovation can be sustained. “This is obviously a fashion thing on the hedge fund side,” says Hyde at Fox-Pitt, Kelton. “The litigational risk of selling third-party products means that banks need to offer them in-house. They have a mission to sell as much as possible to clients, and in doing that they take on a fixed-cost gamble in building the team. But that’s the cut and thrust of banking.”
When investors first consider increasing the proportion of commodity exposure in their portfolios, it turns out to be a difficult task. Rapid rises in, for example, the gold price, as we have seen recently, are alluring, but rapid falls are just as commonplace. Investors can lose huge amounts of money over the course of a lunch hour.
The benchmark West Texas Intermediate (WTI) oil future, for example, was around $24 a barrel in November 2002. At the start of the second week of March 2003 it had shot up to around $38. Ten days later, it was back at $28. This may be an extreme example, skewed by the Iraq crisis, but it is certainly true that commodities are much more volatile than traditional financial assets.
The zero correlation with other financial assets is a powerful incentive to invest in commodities as a hedge. Data consistently shows that during periods when the stock markets are strong, commodities are weak, and vice versa. Certainly, adding a component of commodities through the Goldman Sachs Commodity Index cuts volatility and losses for a portfolio. But Deutsche says that it does not necessarily also boost the portfolio’s returns. “This is disappointing,” says Rodgers in a recent piece of research. “The help that we hoped for from commodities’ lack of correlation with financial assets is not enough to overcome the natural disadvantages that commodities have as a long-term investment in their own right.”
This, combined with investors’ general willingness to consider commodities investment, has prompted Deutsche Bank to launch an ambitious new index. “The problem with commodities is that indexes have performed poorly over the long term,” says Rodgers. “They have had their moments of glory but they have tended not to be sustained. So we set out firstly to find out why that is, and secondly to do something about it. We wanted to keep the nice things, such as the zero correlation to other assets, but we wanted commodities to perform as an investment.”
Of course, this raises the question of whether the fault is with the asset class or the indices that measure it. Whatever the case, the result is the Deutsche Bank Liquid Commodity Index – Mean Reversion, or DBLCI-MR to its friends. It is not exactly a catchy title, but the idea behind it is refreshingly simple.
As the name suggests, the index is based on the six most heavily traded and liquid commodity futures, which are WTI, heating oil, gold, aluminium, corn and wheat. It then draws on the propensity of commodity prices to revert to the mean. The well-known concept of mean reversion is used to describe how commodities trade within defined ranges. These ranges can be wide, but oil, for example, rarely trades outside the $22 to $24 a barrel range for long periods. Similarly, aluminium prices may fluctuate over the course of several years but they tend to return to roughly $1,500 a tonne.
The new Deutsche Bank index recognizes when commodities are trading outside their range and rebalances the weights of the index accordingly. If a particular commodity trades above its five-year moving average, the weighting in that commodity is reduced. If the commodity trades below the average, the weighting is increased. Deutsche says this brings benefits both to the index itself and to the index as part of a mixed portfolio because of high returns and high Sharpe ratios, which measure the extra returns over a risk-free investment divided by volatility.
Straightforward reweighting
The aspect of rebalancing in this index makes it look more like a portfolio than a benchmark, but it is based on a relatively simple equation and no subjective judgement is involved in reweighting decisions. Also, because a small number of commodities are involved, and because fairly high hurdles are set for the rebalancing triggers, changes do not need to be made too frequently.
The index was launched early last month, and the bank’s sales teams have started to market products based on it. The simplest is a total-return note, where the bank invests in the index on behalf of the client and charges a fee. These notes carry maturities of between three and five years, and they are best suited to experienced commodities investors. Other products are principal-protected, and some are more complex, mixing up bond and commodity indices to structure products around the client’s risk appetite and experience.
Deutsche’s new index is broadly designed to smooth out volatility in this asset class and provide a more predictable component to mixed portfolios. But it will have a tough job. The bank is marketing products related to this index to its existing clients and it hopes to see good returns by the end of the year. To do that, though, it has to challenge the dominance of the Goldman Sachs Commodity Index, which has been running since 1991. This is a non-proprietary index that other banks can use to develop new products themselves.
The GSCI is heavily energy weighted. As energy has perhaps the most broad-based relationship with the global economy, this is not a surprise. It may well be more volatile than a mean-reversion-based index such as Deutsche’s. But this is not necessarily a bad thing. “Mean reversion can definitely generate returns,” says Heather Shemilt, vice-president and global head of GSCI marketing. “But we want to stress that’s not all there is. The risk premium is imbedded in the forward curve, and that increases volatility. But volatility generates returns.”
One example of that is that today’s price of, say, crude oil, may be $31. But the one-month forward on crude may be trading at $30, because of the premium that consumers pay in return for having access to fuel immediately. Savvy investors can use that to sell repeatedly at $31 and buy at $30, making an annual return of 40%. This is nice work if you can get it, but it does require sophisticated knowledge and an appetite for risk. “The whole premise of commodity investing is that they are negatively correlated to other assets,” says Shemilt. “Commodities tend to be most volatile when they are generating positive returns – exactly the opposite of equities which tend to be most volatile when they are generating negative returns – and as such you want that volatility in commodities.”
That volatility may prove less attractive to the pension fund manager who wants to balance a mixed portfolio than to a hedge fund manager who wants pure returns. But the growing interest from hedge funds could be very lucrative for banks that develop the right products.
