IFT Notes for Level I CFA^® Program

R50 Introduction to Alternative Investments

Part 5

6. Commodities

Commodities are physical products (that can be standardized on quality, location, and delivery for investment purposes) which include energy (oil), base metals (zinc, lead, copper), precious metal (gold, silver), agricultural products (grains, coffee), and other products (freight, carbon credits). Generally, commodity investments take place through derivative instruments, because one incurs storage and transportation costs for holding commodities physically.

The return on commodity investment is based on price changes only rather than an income stream such as dividends. Commodities are attractive to investors as they are considered a hedge against inflation. Historically, the correlation between commodities and traditional investments has been low.

6.1. Commodity Derivatives and Indices

Commodity derivative contracts may trade on exchanges or over the counter. The popular derivatives include futures, forwards, options, swaps, and commodity index futures.

6.2. Other Commodity Investment Vehicles

Besides derivative contracts, other ways of getting exposure to commodities include:

Exchange traded products (either funds or notes).
Common stock of companies exposed to a particular commodity. However, due to company hedging policies and other idiosyncratic factors (e.g., interest rates, taxes, geographic exposure), the performance of the stocks may or may not track the performance of the underlying commodities.
Managed future funds
Similar to hedge funds, and are actively managed.
Invest in commodity futures and forwards.
Usually follow a 2 and 20 fee structure.
Individual managed accounts
Managed by expert professional money managers for HNIs and institutional investors.
Funds specializing in specific commodity sectors such as chemicals, refineries.
Management fees range from 1 to 3 per cent of committed capital.
Specific commodity sector funds that give exposure to particular commodities.

6.3. Commodity Performance and Diversification Benefits

Commodities are viewed as a good inflation hedge. Commodity prices impact inflation calculation, especially food and energy (oil).

Low correlation with traditional investments results in diversification benefit.
Investing in commodities offers a potential for returns as investors will invest in commodities if they believe prices will increase in the short or medium term.

6.4. Commodity Prices and Investments

Commodity spot prices are a function of supply and demand, the costs of production and storage, value to users, and global economic conditions.

Supplies of commodities depend on production and inventory levels.
Demand of commodities depends on the consumption needs of end users.
Demand may be high while supply may be low during economic growth; conversely, demand may be low and supply high during times of economic slowdown.
If demand changes very quickly during any period, resulting in supply-demand mismatch, it may lead to price volatility.

How are commodity futures contracts priced?

The price of a futures contract can be calculated using the following formula:

where: convenience yield is the value associated with holding the physical asset;

r is the short-term risk-free interest rate

Future prices may be higher or lower than spot prices, based on convenience yield.
For no arbitrage to occur, Future price ≈ Spot price (1+r). But commodities incur storage costs. So, they must be added to the future price and we get Future price ≈ Spot price (1 + r) + storage costs. Storage and interest costs are collectively known as “cost of carry”.
Why subtract the convenience yield? Because the buyer does not possess the commodity as of now, until the end of the contract. Since he has given up this convenience, it must be subtracted from the future price. That’s how we arrive at Future price ≈ Spot price (1 + r) + storage costs – convenience yield
Futures price may be higher or lower than the spot price based on the convenience yield.

Contango: Future price > Spot price

Backwardation: Future price < Spot price

Markets tend to be in contango when there is little or no convenience yield.

Markets tend to be in backwardation when the convenience yield is high.

There are three sources of return for a commodity futures contract:

Roll yield: Difference between the spot price of a commodity and the price specified by its futures contract.
Collateral yield: It is the interest earned on the collateral. It is assumed the futures contracts are fully collateralized and that the collateral is invested in risk-free assets.
Spot prices: Determined by the relationship between current supply and demand.

7. Infrastructure

The assets underlying infrastructure investments are capital intensive, long-lived assets. Infrastructure assets were primarily owned, financed, and operated by the government. Of late, they are financed privately with the intent of selling the newly built assets to the government. The provider of the assets and services has a competitive advantage as the barriers to entry are high due to high costs.

Investors invest in infrastructure assets expecting capital appreciation. Some of the advantages to investors from investing in infrastructure are as follows:

a steady income stream.
diversification because of low correlation of infrastructure assets to traditional investments.
protection against inflation.
match the long-term liability structure of some investors such as pension funds.

7.1. Categories of Infrastructure Investments

Infrastructure investments may be categorized based on different criteria such as underlying assets, stage of development of the underlying assets, and geographical location of the underlying assets. Let us look at the various sub-categories now.

Infrastructure investments based on underlying assets: They can be further classified into economic and social infrastructure assets.

Economic infrastructure assets: These include transportation, communication, and social utility assets that are needed to support economic activity. Examples of transportation assets are roads, airports, bridges, tunnels, ports, etc. Examples of utility assets are assets used to transmit and distribute gas, electricity, generate power, etc. Examples of communication assets are assets that are used to broadcast information.
Social infrastructure assets: These are assets required for the benefit of the society such as educational and healthcare facilities.

Infrastructure investments based on the stage of development of the underlying assets: They can be further classified into brownfield and greenfield investments.

Brownfield investments: These are investments in existing investable infrastructure assets. These may be assets, with a financial and operating history, which the government wants to privatize.
Greenfield investments: These are investments in yet-to-be-constructed infrastructure assets. The objective may be to construct and sell the assets to the government, or hold and operate the assets.

Infrastructure assets may also be categorized based on their geographical location.

7.2. Forms of Infrastructure Investments

Investors may invest either directly or indirectly in infrastructure investments. The investment form affects the liquidity and the income and cash flows to the investor.

The advantages of investing directly in infrastructure are that investors have a control over the asset and can capture the full value of the asset. But the downside of a large investment is that it results in concentration and liquidity risks.

Some of the forms of indirect investments include:

investment in an infrastructure fund
infrastructure ETFs,
shares of companies.

Investing in publicly traded infrastructure companies offer the benefit of liquidity. Publicly traded infrastructure securities also have a reasonable fee structure, transparent governance, and provide the benefit of diversification.

7.3. Risk and Return Overview

Infrastructure investments with the lowest risk have stable cash flows and higher dividend payout ratios, but they also have lower expected returns and lesser growth opportunities. An example of a low risk infrastructure investment is toll roads, or a brownfield investment in an asset leased to a government school. An example of a high-risk infrastructure investment is a fund with a greenfield investment.

Some of the risks associated with infrastructure investments include:

Revenues being different than expected.
Leverage creates financial, operational, and construction risk.
Regulatory risk

8. Other Alternative Investments

There are many other investments that are not considered traditional investments (stocks, bonds, and cash). These often fall under the category of collectibles. Collectibles are tangible assets such as fine art, fine wine, rare stamps, coins, jewelry, watches, sports memorabilia, etc. Risks associated with collectibles include the following:

These do not provide current income.
These are very illiquid instruments and hence the risk is very high.
Investors must have a personal interest/expertise in these items to make the right choice for investment so as to avoid fraud, fake, etc.

9. Risk Management Overview

9.1. Investment and Risk Management Process

Both investor and the investment manager must be concerned about risk management to ensure that the investments are consistent with the portfolio policies. Each alternative investment has a separate fund manager, so the investor must also ensure that the portfolio risk is effectively managed by the manager across different alternative investment categories. Additional points to keep in mind:

Risks vary across alternative investments. For example, the risks associated with private equity will be different from the risks for direct real estate or commodities. Private equity investments have a long lockup period and are illiquid, so the right fund/manager selection is important.
Historical returns and standard deviations of the indices may be different from the returns and volatility of the alternative investments; the returns tend to be biased upward. The indices are created based on funds voluntarily reporting data.
Reported correlations may vary from actual correlations. Performance may be highly correlated with business cycles and correlations keep changing. During one period, you may observe high correlation whereas low correlation in another period. In short, the investor must do due diligence to assess the risk and use the appropriate correlation number before investing (for proper diversification).
Hedge fund risk is monitored by a chief risk officer, who should be separated from the investment process. Limits on leverage, sector, and individual positions must be specified.

9.2. Risk-Return Measures

Traditional risk measures such as the Sharpe ratio assume a normal distribution of returns. The measures are not always appropriate for alternative investments because:

Many alternative investments exhibit asymmetric risk and return profile, which means they might have high kurtosis (leptokurtic) and negative skewness. Downside risk measures such as VaR and Sortino ratio will underestimate the loss for a negatively skewed distribution.
Alternative investments such as hedge funds and private equity have limited transparency. This is because the alternative investment industry is not as regulated as traditional investments.
Most alternative investments are relatively illiquid.

9.3. Due Diligence Overview

Hedge fund and private equity returns depend heavily on the fund manager. Due diligence of the manager is important to ascertain he has the right skill and expertise. When evaluating past results, investors should be wary of consistent, good performance as there is a possibility of fraud.

Security Market Indices: Indices for Alternative Investments

The material below is reproduced from an earlier reading as it summarizes what we have seen so far.

Commodity indices consist of futures contracts on one or more commodities.
- Performance of index and underlying commodities can be different.
- Common to have multiple indices with same commodities, but in different proportions; weighting methods are also different; different risk-return profile.
Real estate indices represent the market for real estate securities and the market for real estate.
- Appraisal indices, repeat sales indices, REIT indices.
Hedge fund and private equity indices
- Constituents determine the index.
- Poorly performing funds are less likely to report.
Index returns overstated due to survivorship, backfill, and other biases. Survivorship bias occurs when an index is composed of only surviving companies over a period, which tends to overstate the historical estimates of the equity risk premium. Backfill bias occurs when a new fund enters a database and historical returns of that fund are added (i.e., “backfilled”). These biases cause the index returns to be biased upward.