“Should Pension Funds Invest in Commodities? If So What Are the Implications for Them....and Others?”

1. “Should Pension Funds Invest in Commodities? If So What Are the Implications for Them....and Others?” Thomas Schneeweis Michael and Cheryl Professor of Finance University of Massachusetts March, 2012

2. Summary • Take Aways • Benefits of Commodity Investment • Commodity Investment • Issues in Commodity Investment • Commodity Investment: Then, Now and Future • How To Get Started

3. Take Aways • While it is impossible in a short synopsis to convey all of the benefits of commodity investments, commodity investments have been shown to provide additional return enhancement as well as risk reduction opportunities to traditional and alternative investments. • Historically, indirect investments (e.g., equity ownership of firms specializing in direct commodity market production) have been the principal means by which many investors obtain exposure to this asset class. However, in recent years, the number of investible commodity indices and commodity-linked investments has increased dramatically. Going forward, commodity investment will be tailored to meet the unique ‘return and risk’ concerns of investors (pension funds, endowments, …) • Today, and more importantly future commodity price relationships, may be poorly represented by past price relationships (corn is no longer just a commodity). In short, studies which emphasize past empirical relationships may be less important that those which offer a detailed analysis of future return and risk relationships.

4. Benefits of Commodity Investment Traditional Assets and Commodity Performance (1992-2011) Note: Commodity investment has been presented as a ‘potential’ means to provide additional return enhancement as well as risk reduction opportunities relative to stock and bond investments and non-traditional investments such as private equity, real estate, hedge funds and managed futures, as well as to portfolios of traditional assets and various alternative investments especially in periods of poor equity performance.

5. Commodities Investment • Not All Commodities Are Alike • Past is Not Prologue • What to Invest IN – Is There A Difference?

6. Not All Commodities Are Alike Note: Each commodity sub index has its own unique risk and return characteristics as well as its own unique diversification benefits relative to an existing investment portfolio

7. Not All Commodities Are Alike Note: The sources of returns to commodity are a function of the investment form (e.g., commodity futures are impacted by changes in spot prices (supply and demand) as well as changes in cost of carry and storage issues). However, research has shown that those commodities have which are susceptible to supply constraints have shown to have the potential for a positive expected return while those commodities for which supply constraints are short run in nature may require a more active trading strategy.

8. Commodity Performance: Past May Not Be Prologue Note: There have been dramatic changes in commodity markets over the past twenty years. What is surprising is that except for the period surrounding 2008, the band of historical volatility has remained between 20 and 30% (rolling annual volatility). Similarly, the correlation of a diversified portfolio of commodities (SP GSCI) with the S&P 500 has moved in a band above and below zero. Recently the correlation is at the high end but investors should be aware of the changing nature of correlations patterns.

9. What To Invest In: Is There A Difference? • Go Public • Equities/Mutual Funds • ETFs/Closed End Funds • Go Private • Hedge Funds • Private Equity Investment • Go Green • Commodity Futures • Equities • Go Index • GSCI, DJ-UBS, …..

10. Where to “GO” Note: There is a wide range of ‘commodity based’ investment vehicles, each with their own unique return and risk characteristics. Difference in performance exist due to differences in the underlying investment vehicle (futures versus equities), the trading process (production weighted indices versus dynamically traded commodity indices), fund form (mutual funds versus hedge funds versus CTA) as well as in product emphasis (diversified or targeted (green, timber, water..).

11. Issues in Commodity Research: A Personal View • Who are Speculators and What are They - Many institutions and individuals hold commodities as hedge toward other asset classes and while not buying and selling commodities based on commercial plans they do purchase commodities based on a diversified “asset class’ business plan;. In short, is an investor who uses commodities as an indirect hedge to expected portfolio risk a speculator. Moreover, in a global ‘demand’ market the marginal impact of Pension Funds is an open question. • Regulation and Second Order Impacts; A particular regulation may result in long term changes in markets beyond that anticipated in original legislation or may have impacts on trading structures well after the initial reason for the legislation is of no significance. • What Is Available May Not Be What You Want: Commodities may have a role in any individual or institutional portfolio but users should detail desired return and risk exposures (e.g., for portfolios with investment in private equity (oil, ..) or commodity firms – simple passive investments in index products may make little sense). Remember people sell what they can not what they should • Misunderstanding of Causal Relationships in Commodity Markets: Simple statistical measures representing relationships within and across asset classes my be that; too simple, and may hide the actual dynamics of commodity price movement. How one comes to grips with the macro and micro processes dominating commodity markets is at the heart of understanding the impacts of commodity investing. • Issues In Trading Structure: Few individuals can afford insurance against the 100 year flood. (1998 and 2008 may happen again for different reasons) but the cost of insuring against a “black swan’ may have severe short run and long run costs. • Data Quality and Understanding: Again, be careful of any analysis without a full understanding of the data used (Example: some studies compare futures prices to spot – but futures prices have low trading costs compared to spot. Some academics have tried to show that futures lead spot but in reality the spot was moving that way all the time (just within trading cost bands).

12. Where to in the Future • New Investor Demand Bill Gross Explains How To Make Money In A 'Delevering World‘ - (Reuters) - Bill Gross, who runs the world's biggest bond fund at Pimco, said he favors high-quality, short duration and inflation-protected bonds ….. He also favors commodities .(Gross: “Commodities and real assets become ascendant, certainly in relative terms, as we by necessity delever or lever less. “) whose prices rise with inflation and are limited supply. (NEW YORK, March 27 | Tue Mar 27, 2012 8:56am EDT) Read more: http://www.businessinsider.com/bill-gross-delivering-in-a-delevering-world-2012-3#ixzz1qK6Z9KZ6 • New External (Non-U.S.) Demand China's Sovereign Wealth Fund Is Looking to Invest in Commodities: Posted Feb 1st 2010 4:45PM by Connie Madon -Filed under: International Markets, China, Commodities. China has a $300 billion dollar sovereign wealth fund called the China Investment Corp. The fund has been investing natural resources which China needs to develop its economy. For example, China has had talks with Brazil, the world's second biggest iron ore exporter and Mexico, the second largest silver producer. In 2009, CIC made purchases in the following companies: • It bought 17.2% of Teck Resources Ltd, Canada's largest base metals producer for $1.5 billion. • It bought an 11% stake in a unit of Kazakhstan's state run energy company. • Then it purchased 45% of Nobel Oil Group of Russia. • New Product Demands The SP GSCI Index is twenty years old. In that period new forms of index and active portfolio based products have come into existence as investor needs changed. Today there is an increasing demand for targeted commodity based products (e.g., ETFs) that are both passive and active (dynamic rebalancing) in form. In addition there is an increasing demand for ‘Fund’ specific products (commodities without energy, green commodity products…..).

13. How To Get Started/Who Do You Trust? • Internal Asset Management • Dependent on size and breadth of Commodity Investment • Four person commodity team – between $1 million and $2 million • Investment in personnel and office costs • Compliance costs • External Asset Management • Consultants: Private equity, Advisors (external managers and fund based investment vehicles) • Question as to quality and knowledge of external consultants (e.g., the CFA offers little as to commodity knowledge – The CAIA (Chartered Alternative Investment Program (www.caia.org) offers background on range of alternative investments including commodities but as CFA no active training). • Self Education • Incubation Funds, Tracker Funds…… Find set of external products and create lower cost tracker funds. Note current use of GSCI investment is due more to fact that GSCI has the longest history as investment benchmark such that any deviation from GSCI as investment vehicles adds tracker risk even if many active investors have created products with more attractive investment characteristics than the SP GSCI.

14. Appendix: What Are Commodity Markets? • Commodity markets: Commodity markets include markets for a wide range of raw or primary products(oil, food, precious metals, etc.). Commodities are traded on a wide range of centralized and over the counter markets both in the United States and Non-U.S. Markets. Commodities are available both spot markets as well as though futures markets (in which they are bought and sold in standardized contracts) as well forward and other OTC investment vehicles. • Direct Investment - Commodity Futures/Forward Markets: Commodity futures markets allow those who expect to have or need that asset to establish a price and quantity ahead of time. Futures market attracts hedgers who minimize their risks. Rather than make or take physical delivery, most futures players eventually close their positions with offsetting trades. Spot and futures market prices that move too far out of line do encourage some traders to make or take delivery, however, the threat of such arbitraging generally drives spot and near-delivery futures prices together • Indirect Investment - Historically, direct commodity investments through futures markets have been a minor part of investors’ asset allocation decision. In contrast, indirect investment (e.g., equity or debt ownership of firms specializing in direct commodity market production) were historically the principal means of obtaining claims on commodity investment. In recent years, however, the number of investible commodity indices and commodity-linked investments has increased dramatically. • Active/Passive Investment: There is an increasing demand for financial products based on commodity investment that provide commodity products with unique return (short term or longer term investment profiles) or risk profiles (long short commodity, arbitrage, collar)).

15. Background Information There are a number of traditional and alternative investment indices used in this analysis. For the more traditional indices it is assumed that the reader is familiar with the investment index used: For background information on the commodity, hedge fund, and CTA indices used the reader is directed to the following web sites. SP GSCI - www.standardandpoors.com/indices/sp-gsci HFRI Hedge Fund Indices: www.hedgefundresearch.com Barclay CTA Index: www.barclayhedge.com ABCI: Alternative Benchmark Commodity Index (Formerly Known as BCI Commodity Index): www.bache.com

16. Disclaimer • The securities and strategies referred to in this presentation are shown for illustrative purposes only and should not be interpreted as any form of investment recommendation. The information contained in this presentation has been obtained from sources believed to be reliable, but their accuracy cannot be guaranteed. In addition, the opinions expressed in this presentation are the author, are subject to change and are likely to evolve over time. This presentation does not constitute an offer to sell, or a solicitation of any offer to buy, any product. If any such offer or solicitation is made in the future, it will be made only by appropriate written documents containing specific terms, conditions, limitations and risk factors.