DR.CHENJIAZI ZHONG

Endowment Spending Policy

One of the most difficult challenges that any investment committee member of endowments and foundations face is choosing a spending policy that will best balance two competing goals: maintaining the level of current spending, and growing or preserving the purchasing power of the endowment assets over time even after making charitable distributions.

The spending rate is usually measured in terms of an amount or a specified percentage of a moving average. Some institutions are required by law to spend a certain amount annually, e.g., 5% of the portfolio balance; others may have discretion in selecting a spending rate. According to NACUBO study, the average annual effective spending rate for U.S. college and university endowments and affiliated foundations in the fiscal year of 2012 was 4.2%.

A spending policy provides endowments and foundations with a plan that may grow each year by an inflation amount; additionally, it establishes a guideline that will meet the cash flow requirements of the endowment or foundation; beyond that, the policy provides guidance in the application of a disciplined approach to transactions and making sure it is done on a predictable and consistent basis.

Therefore, endowment and foundation portfolios by their nature require even more awareness in purchasing power protection, from inflation and currency devaluation. Inflation is most damaging to interest-generating investments, such as stocks and cash equivalents.

Benefits of Commodity Investments

“Commodities tend to zig when the equity markets zag.” — Jim Rogers

The approaches to active risk management, besides hedging strategies, such as hedge funds and managed futures, investors can also seek the investment styles based on “non-correlation.” The return patterns of commodities have low correlations to the broad stock market, but a high correlation with inflation, particularly unexpected inflation. Commodities are real return, real assets that are part of the consumable and store-of-value super asset class. It is interesting to note that commodities have low correlation with one another, so they offer uncorrelated investment opportunities across various commodity markets. Historically, commodities have performed relatively well through times of high inflation and currency depreciation. Some types of commodities are held outside the traditional financial system. Empirical evidence shows that the efficient frontier with commodities assets and futures tends to be above the efficient frontier without this opportunity set, and it dominates a typical portfolio of traditional equities, using CAPM expected returns, in another word, an allocation to commodities can substantially improve the portfolio efficiency.

What is the optimal percentage of portfolio to be allocated to commodities? I would say this is largely determined by the expected risk premium. Besides the diversification and inflation-hedging effects, one of the notable benefits of investing in commodities is “event risk hedging,” when equity price tends to be negatively impacted by political distress, financial crisis, or natural disasters; commodities price generally reacts positively to such occurrences. Furthermore, agricultural commodities provide a natural hedge against business cycles. In the April 1988 issue of The Journal of Political Economy, Eugene F. Fama and Kenneth French uncovered a strong business cycle component for metal futures, consistent with the effect of inventory levels predicted by the theory of storage. Years later, Gary Gorton K. Geert Rouwenhorst showed that long investors in commodities futures markets have historically received a risk premium of 5% per annum in return for assuming some of the price risk of short hedgers. Thereafter in 2006, they argued that commodities are effective diversifiers of systematic risk; they found that commodity futures perform well in the early stages of a recession and poorly in later stages of a recession, which is in exact contrast to equity performance.

Evolution of Commodities Investment Products

During the 1980s, commodities were followed mainly by people who worked as farmers, drillers and miners, and companies that purchased their products. Until 1991, Goldman Sachs created the Goldman Sachs Commodity Index (GSCI), and then in 1996, Standard & Poor introduced the S&P GSCI tracking ETF.

Since 2000, exposure to the commodity asset class has gone mainstream. New investment vehicles have fueled this change such as commodity-focused mutual funds and ETFs. In 2002, PIMCO launched its CommodityRealReturn Strategy Fund, and in 2004, the largest physical gold bullion backed ETF, the SPDR Gold Shares (GLD) was established. During the mid-2000s, energy master limited partnerships (MLPs) grew rapidly. Around the same time, some enhanced commodity indices were created. In the April of 2006, the first ETF allowing U.S. investors to invest directly on the price of crude oil was set to begin trading on the Americal Stock Exchange. Over the last decade, commodities markets expanded access to institutions and sophisticated investors. However, as many portfolio managers and investment consultants have realized, increased access does not assure successful results.

Active Commodities Strategies: Directional versus Relative Value

When we look at commodities market, we need a strategy. If we don’t have one, we don’t have a market, and that’s how it works. There is increasing focus on active management in commodities, rather than just investing in them, especially in the institutional investors’ space, although we can still see strong inflows into passive strategies for diversification. Commodity trading strategies can be separated into two broad groups, i.e., directional and relative value.

• In terms of commodities investing, a directional strategy expresses a view on market position, either a net long or net short. It is betting on the direction the overall market is going to move in. It is to some extent similar to the “market timing” concept in the equity long/short style. A fundamental directional strategy is based on the supply-and-demand factors of commodity sectors, while a quantitative directional strategy uses technical or quantitative models to identify overpriced and underpriced commodities.
• Relative value commodity managers focus on a particular sector to add economic value. These strategies are basically spread positions that are taken in the expectation that the spread will change due to some fundamental relationship that govern supply and/or demand of one or both spread legs. John Brynjolfsson, CIO of Aliso Vjejo, subadviser to the Eaton Vance Commodity Strategy Fund, uses active strategies from roll timing and curve positioning to relative-value trades based on geographic and qualitative anomalies.

Fundamental Analysis for Commodities

Fundamental analysis of commodities investing is about demand/supply balances, production trends, and market forecasts. Geographically, fundamental analysis considers the factors and conditions of both the OECD and non-OECD member countries.

Supply analysis typically considers current productions capacity, expectations, greenfield projects and brownfield projects (for environmental impact study), resource nationalization (for capital budgeting purpose), supply constraints (labor, equipment, power shortages, grade quality, infrastructure), and inventory levels. Below is some up-to-date information on demand catalysts:

• Global population is currently estimated at 6.9 billion by the United Nations, and is projected to increase to 8.6 billion by 2035, and virtually all of this will be in the developing nations.
• As standards of living rise in developing nations, domestic consumption and urbanization, fueled by a powerful wave of rising purchasing power, will increase demand for many basic commodities.
• The infrastructure demands in the BRIC countries, i.e, Brazil, Russia, India, and China, will require vast quantities of natural resources.
• Global oil demand is projected to increase to 111 million b/d by 2035, according to the Energy Information Administration; developing nations are expected to account for 84% of the increase in world energy demand.

Demand analysis analyzes leading economic indicators, global infrastructure build, industrialization and urbanization, and speculative money flows. Here is some up-to-date information on the supply-side catalysts of commodities:

• Environmental regulations are increasing the costs of developing fossil fuels globally.
• As governments look for new tax revenues to reduce budget deficits, resource producers are facing tax pressures.
• The fact that mining production costs are rising even faster erodes producers’ profit margins and incentive to develop new resources.
• New production of many commodities will depend on an aging transportation infrastructure that is already capacity-challenged.

Exchange rate movements also have considerable effects on the supply and demand for commodities. A general depreciation in the dollar increases the price of commodities, as export countries demand a higher price to compensate for the transaction loss. In a period of economic expansion, the central bank is likely to raise real interest rates, which decreases the demand for commodities; however, an offsetting effect might occur as during economic expansion, demand for commodities theoretically should rise.

The Impact of Time in Commodities Investing

In addition to demand/supply factors, time is also a powerful fundamental. Time enters explicitly into formulas that are used to price options (theta), and it features in all elements of futures pricing, i.e., the cost of financing, cost of storage, and convenience yield.

In many instances, cost of storage is absent from commodity market analysis. The passage of time is misapplied in the investment process. Investors express a long-term view on supply and demand trends, but they adopt short- to- medium-dated instruments to achieve the exposure. In fact, costs of rolling are fairly high, and the returns on short-term instruments do not track long-term investment closely. Therefore, adopting a strategy that can help to actively manage such impact of time is highly critical in commodity investments.

Final Thoughts

• Most commodities exhibit an inflation-hedging property when compared with U.S. inflation; however, for European and Asian countries, the inflation-hedging effect becomes more ambiguous.
• The fact that an increase in real interest rate decreases the price of real assets tends to exhibit a time lag, as investors react to increasing opportunity costs and shift part of their financial capital out of commodities.

References:

1. The Alternative Answer by Bob Rice 2013
2. Bjornon and Carter (1997)
3. World Population Prospects, the United Nations, Department of Economic and Social Affairs: http://esa.un.org/unpp
   
4. World Urbanization Prospects, the United Nations, Department of Economic and Social Affairs
5. Annual Global Energy Forecast, Energy Information Administration