Monday, 28 May 2018

Herd on the Street

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SwissInvest strategist Anthony Peters decries the extent of benchmarking in the commodities market

Anthony Peters, SwissInvest Strategist

OVER THE 30-ODD years that I have been hanging around street corners in the City, I have developed a fine little network of what I usually refer to as “low people in high places”.

Thus it came about that I was lunching with the principal of a commodity trading adviser of which I am, for my sins, a non-executive director. We talked a lot about the collapse of the Peregrine Financial Group in the US and about the commodities market in general – as you would expect a NED of a company to do with the MD when sharing a curry and a large glass of lager.

What distinguishes the commodity futures world from the securities market is the massive concentration of investment dollars, with the vast majority of funds in the hands of just a handful of investment managers. Although concentration on the “big guys” is pervasive in all asset classes, the commodity world is more seriously beset than others by the problems that this brings.

Let’s face it, since the early 1990s, investing clients – the trustees of pension funds, for instance, or the boards of insurance companies – have become ever more mesmerised by the seeming comfort of indexing and benchmarking.

The principle is simple: it no longer matters how wrong I am, so long as I am as wrong as my peer group. Indeed, being as wrong as everybody else is, in an index-driven world, as good as being right.

FOR UNFATHOMABLE REASONS, investors keep on falling into the trap of believing that markets can be fitted into neat mathematical models. The quants calculated their VaRs and their Sharpe ratios, their correlations, their standard deviations and their tail risks and sold them to unsuspecting investors as the panacea.

Such mumbo-jumbo does little to mitigate portfolio risks but it certainly neutralises the career risk – when I get it right, nobody remembers; but when I get it wrong, nobody forgets – that comes with straying from the norm. And if the herd mentality needed official accreditation, the CFA qualification did just that.

As my commodity friend suggested, why should the historical data that are used for the calculation of VaR and Sharpe be of any relevance in understanding what is about to happen – and to day-to-day trading decisions? If the LTCM fiasco didn’t teach that lesson, nothing will.

The concentration of investments in commodity futures funds makes the situation worse rather than better. Not only are far larger blocks pulling the same way, but they are prone to track a more limited universe of indices – not least the Goldman Sachs Commodity Index, which tops the pile.

However, the nature of commodity contracts is that they all expire and roll on preset dates, which leaves all the respective investments, especially those in open-ended funds and ETFs, with a need to do the same trades across the same period. If ever you wanted to know what it felt like to fly a daylight bombing raid on Schweinfurt in a Flying Fortress, try rolling a portfolio of commodity futures in a market that knows what you have to do and when.

The herd mentality has in many ways increased market volatility rather than diminishing it

Too many of the commodity-related investment products – well over 50% at last count – are linked to either the GSCI index or alternatively to the DJ-UBS Index.

While such products do exactly what they say on the tin, this is not surprising because they are the tin. And if the tin is itself imperfect, then anything related to it must, by definition, be imperfect too. As the two indices encompass such a large part of the overall market, they become their own self-fulfilling prophecies. Can that really be the objective?

INSTITUTIONS WITH THE desire to protect themselves from the vagaries of market direction might be able to do so by benchmarking, but instead it immediately exposes them to a different set of risks which are generally not understood by the investing public.

Indices also encourage investors to track performance in real time. Pension funds that are supposed to think in decades have been moved towards quarterly performance measurement, which is largely self-defeating.

Despite the platitudes about their importance, investment banks and brokers don’t make much money from buy-and-hold clients. Therefore, any tool that helps to necessitate frequent trading is just what the banker ordered. So replace directional risk with benchmark risk – measured on a daily basis – and volumes are guaranteed.

The events of the past few years should have proven that active management by small, dedicated firms is the best way to go, but those responsible for doling out the cash have evidently decided that there is safety in numbers and that it is better to be a zebra than a lion.

Thus, the herd mentality has in many ways increased market volatility rather than diminishing it. When nobody dares to stand in the way of a falling market – or a rising one, for that matter – whither common sense?

As my commodities man with his CTA believes, there are the big fish and those who swim around them, cleaning their backs and making a decent living off the pickings. The bigger the big fish, the better the living. But how do you attract investment dollars when too many seem happy to live in the comfort of losing money along with everybody else?

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