Passive is Massive…but does it work with Commodities?


“In investing, what is comfortable is rarely profitable” - Rob Arnott, Founder of Research Affiliates

The Passive Market;

Passive is massive…and by all accounts it’s only getting bigger. Some estimates now put passive allocation (ETF’s, ‘smart beta’ & ‘risk parity’ products) at close to 40% of all institutional and large family office investment. That’s an incredible figure when you think that it stood at around 20% just under 5 years ago. Boston Consulting puts total passive investment at a whopping $74 trillion.   

According to a Morningstar report released earlier this month, assets held in mutual funds and ETF’s that specifically track US equity indexes have just surpassed those run by stock-pickers for the first time. 



It’s relatively easy to understand why this increase has occurred. Post financial crisis, if you were underweight equities you would have probably underperformed as stock markets trended uncontrollably up. The obvious and most broad access to this rally was via an ETF.

ETF’s are also easy to invest in. They are liquid and usually have an investment thesis relatively simple to understand.

On top of this they are cheap…and getting cheaper with large providers having the advantage of economies of scale. Fidelity have even recently issued index mutual funds with zero annual fees. This versus hedge funds that had been charging high rates with little to show for it.

Commodity Markets;

This all works well for asset classes like Equities or Bonds (in an environment of low vol / cheap dollar funding / expanding CB balance sheets), where more often than not the sector moves in tandem and the diversification of a basket of ETFs offers good risk adjusted returns on the cheap.

However, we would argue the same cannot be said of commodities.  

Commodity markets tend to not trend in tandem. The divergence of particular commodity performance has been made all the more apparent since QE (quantitative easing) diminished, QT (quantitative tapering) began and the US/China trade war commenced.

Therein lies the problem.

Some allocators are still mandated to invest a certain percentage of assets into the commodity sector. The easiest way to do this is to invest in a broad ETF like the Goldman Sachs Commodity Index (GSCI) or the Bloomberg Commodity Index (BCOM).

These products work when the global economy is booming off the back of a Chinese commodity supercycle, for example, but are less effective in an environment filled with geopolitical tension (think Trump trade war, Iranian sanctions, etc). The only way to produce real alpha in the current climate is to actively manage exposure.   

Active management allows talented managers the ability to navigate a sector over the full market cycle. This is particularly important in times of increased volatility.

The diversification advantage of investing in an S&P500 ETF can actually have a negative effect on a commodity ETF like BCOM. The exchange traded fund could have benefited from investing in nickel (up over 35% this year), whilst suffering the woes of Tin (down over 10% this year).  Conversely, GSCI is almost 60% weighted to energy, so you’re principally overweight that sector and at its whim.

Commodity ETF’s like the two mentioned above are also long commodities 100% of the time. That comes at a price (storage cost, $ funding costs, etc). This could mean that in the long run, you might end up flat even if prices rally.

According to Arion PM, Matthew Collis, active management can improve investors risk-adjusted returns verses ETF’s;

“As we enter a period of political and financial uncertainty the pillars of the past decades equity bull run will be tested. Higher volatility and creeping inflation should place the argument for active commodity management at the forefront of any investment committee.

We are also yet to test the liquidity of ETF’s, which have built significant market risk in a meaningful way. However, that may be closer than some wish to admit.”

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About Arion: Arion is a commodity focused investment adviser and manager with offices in London. Arion is authorised and regulated by the FCA (registered no. 742037), is registered with the U.S. Commodity Futures Trading Commission (CFTC) as a Commodity Pool Operator and Commodity Trading Advisor and is a member of he National Futures Association (NFA).