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John Dizard of the FT has recently written two interesting columns. One noted that because commodity index funds' futures contract rollovers are predictable, traders have been making around 1.5% per year at the expense of commodity index investors. The other suggested that VIX futures were not an effective hedge against a stagnant equity market. Any reaction?
John Dizard (as well as his brother Stephen, who spent much of the last two decades running Citigroup's global special situations group) is a very smart guy, whom one does not disagree with lightly. In this case, we're not going to try. Rather, we'd like to expand a bit on his remarks. As is true of most actions that are predictable, there is no denying that commodity index funds' futures contract rollovers provide opportunities for other traders to earn low risk returns. The same used to be true of predictable reconstitutions of membership in the Russell 2000 Index. But over time, Russell changed its index rules to make this arbitrage harder to execute. We don't doubt that this will also happen with commodity index products. However, even with the added 1.5% in effective cost, we still believe that the substantial long-term portfolio diversification benefits one can obtain from investing in commodities make it money well spent. Regarding the VIX, the point Dizard made is accurate: it "will not protect you from the chronic slow losses brought about by a bear market." However, to use a sports analogy, that is not its role on a portfolio team. Long term protection against chronic equity bear markets is more effectively provided by other asset classes, such as high grade bonds, timber, property, and perhaps uncorrelated alpha strategies. Rather, the role of the VIX is more akin to crash protection, or a hedge against so-called extreme downside "tail events." As we have noted in the past, avoiding large losses is perhaps more important than earning an extra .5% in average return when it comes to achieving long term portfolio goals, particularly for investors who are regularly withdrawing funds. Under these circumstances, we continue to believe there is a valid role for some volatility exposure in many portfolios, and hope that a product that makes it available to retail investors is eventually launched.
What do you think about the new global water iShare that Barclays just launched in the U.K.?
On the one hand, we appreciate the trend toward growing water scarcity in many parts of the world. On the other hand, it is very hard to see how this that trend will easily translate into high returns for investors - the political obstacles to raising water prices in line with the market value of the commodity are extremely challenging. That being said, there may be high returns to earn from investing in water purification, conservation and other technologies that will see rising demand as traditional water sources are put under increasing pressure. But that makes a water fund just a very specialized technology fund, the returns on which should be strongly correlated with overall equity market movements. In sum, it is hard for us to see how one can make a convincing argument treating water as a separate asset class.