Editor’s Letter

Commodity investment and analysis often include a number of concepts that are unique to commodities. This is owing to the fact that commodities are fundamentally different from many traditional securities. Since most commodities are used as inputs in the production process, many believe that they should provide good hedges against inflation. Empirical evidence provides some support for this claim. In particular, compared with stocks and bonds, commodities tend to provide a much better hedge against inflation. The following table displays the correlation between inflation and stocks, bonds, and commodities (see “Facts and Fantasies about Commodity Futures Ten Years Later,” by Geetesh Bhardwaj, Gary Gorton, and Geert Rouwenhorst, Yale University, 2015).

While commodities derive their value from their role in the production process, financial securities derive their value from being claims on a profit-generating enterprise. Even among alternative investment strategies, commodity strategies are unique. Most alternative investments involve trading strategies based on the purchase and sale of traditional securities. For example, many hedge funds typically take long and short positions in publicly traded stocks and bonds. The valuation methods and risk factors of private equity strategies are closely related to those of public equity strategies. Investment strategies such as those based on earnings per share (EPS) forecasting or value-based investing, which are effective when applied to traditional assets, do not apply to commodities.

The opposite is also true. Commodity strategies based on an understanding of seasonal patterns in commodity demand, and market pressures leading to the existence of backwardation and contango, do not apply well to traditional markets. While this is attributable partly due to differences in the way the commodity and traditional securities markets are organized (e.g., futures versus cash), it is also owing to the fundamental difference between the economic and market factors driving traditional equity and fixed-income securities versus those driving commodities.

Available historical empirical evidence going back close to 200 years shows that in the absence of significant demand shocks, the prices of exhaustible commodities rise at a rate that is lower than the prevailing interest rate. Examination of commodity prices suggests four super-cycles during 1865–2009, with each cycle lasting around 30 to 40 years. The 2007–2009 global economic crisis was preceded by a commodity price boom that was unprecedented in its magnitude and duration. The real prices of energy and metals more than doubled in the five years from 2003 to 2008, while the real price of food commodities increased 75 percent. While in the former case prices reached one of the highest levels in history, in the case of agriculture it was a reversal of the strong downward trends experienced since the 1980s. In this sense, it can be said that there was a boom of mineral, not of agricultural, prices. Similar to earlier periods of high prices, the recent one came to end when global economic growth slowed down, diminishing demand pressures on commodity prices. Some commodities have fully recovered, while others are still well below their previous peak. Overall, diversified commodity investments have not performed well during the past few years, as shown in the next table.

Perhaps now that most of the global economy seems to have recovered from the global financial crisis, we may see higher inflation rates, interest rates, and commodity prices.

This issue of The Journal of Alternative Investments consists of two parts. The first one deals with commodity markets and investments. In “Spicing Up a Portfolio with Commodity Futures: Still a Good Recipe?” Robert Daigler, Brice Dupoyet, and Leyuan You investigate whether employing individual commodity futures provides a superior optimized risk–return strategy relative to an equity portfolio, given the recent rise in correlations between commodity and equity markets. They report that commodities can still provide diversification benefits and, in particular, portfolios of equities and commodities exhibit lower tail risk (reduced potential extreme losses) relative to the equity indexes.

In “Oil Price Movements and Risks of Energy Investments,” Gregory Brown, Raymond Chan, Wendy Y. Hu, and Jian Zhang examine the historical relation between oil price movements and both public and private equity investments in the energy sector. By utilizing two proprietary private equity databases (one at the fund level and the other at the company level), the authors are able to show that investments in energy-focused private equity offer diversification benefits relative to similarly focused public equity and direct energy commodity investments. Finally, in “Time-Varying Risk Premiums and Term Premiums in Commodity Futures,” Denis B. Chaves shows that the excess returns of long-dated futures contracts over short-dated commodity futures contracts are strongly predictable, both in the time series and in the cross section, by roll yield spreads. Strategies that exploit this predictability show sizable Sharpe ratios and are uncorrelated with strategies that exploit predictability in risk premiums using the basis as the signal (contango and backwardation).

The second part of this issue deals with private equity. In “Synthetic Peer Benchmarking for Diversified Private Equity Programs,” Jeroen Cornel observes that private equity by its nature is not transparent, and therefore it can be challenging to monitor, examine, and benchmark the performance of private equity investments. The author develops a simulation technique to peer benchmark diversified private equity programs, using a large universe of underlying funds. The method considers a program’s exact composition and number of holdings. It overcomes three key challenges that have prevented peer benchmarking of diversified programs until now: a lack of comparable data, a misleading practice of averaging underlying performances of individual funds, and no visibility on the drivers of out- (or under-) performance.

In “An Analysis of Returns of Moderately Aged Buyout Funds with Low Residual Values,” Jeffrey Hooke, Steven Hee, and Ken Yook focus on moderately aged leveraged buyout funds that have had the opportunity for multiple portfolio company liquidations, or have been fully liquidated. Examining 186 funds in the vintage years from 2000 to 2007 with complete cash flow data from the Preqin database, they find that 61% of funds beat the S&P 500 plus 3% (a common benchmark), and 39% did not. Funds originated during the boom years (2005 to 2007) are less successful, with 41% beating the benchmark to date, and 59% falling short. Thus, they find that funds from the earlier vintage years have better performance, relative to broad equity market benchmarks, than those from the later years. In examining a group of fund families with three or more funds, they find no strong evidence of consistency.

The last article in this issue, authored by Yindeng Jiang, is titled “Introducing Excess Return on Time-Scaled Contributions: An Intuitive Return Measure and New Solution to the IRR and PME Problem.” The author observes that while the internal rate of return (IRR) remains widely used despite its well-documented flaws, considerable progress has been made in the literature on the search for a proper measure of performance of illiquid investments. Most recently, two general approaches have been proposed, namely the average internal rate of return (AIRR) approach and the aggregate return on investment (AROI) approach, and the following cash flow based metrics have appeared in the literature: the economic AIRR, the index comparison method (ICM)-based AROI and the direct alpha method. Motivated by the AIRR approach, the author presents a new cash flow-based metric, excess return on time-scaled contributions (ERTC), which is free from all of the IRR flaws and represents a solution to the public market equivalent (PME) problem.

TOPIC: Real assets/alternative investments/private equity

Hossein Kazemi

Editor-in-Chief

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