Overview of Commodities Markets

Commodities are tangible assets such as oil, metals, and grains. They are raw objects, produced by nature or man, that you can touch. Like non-tangible assets (such as stocks and bonds), they offer the potential for investment return with associated risk. Every year approximately $3 trillion of new commodities are produced globally, and this annual production represents 5% of all outstanding liquid assets in the World Wealth Portfolio.

Rather than purchasing physical commodities, many commodity investors prefer to gain exposure through commodity futures, which are contracts to buy or sell commodities that trade on regulated exchanges. Commodity futures have precise and well-publicized contract specifications, and futures trades are settled through clearinghouses that guarantee each executed transaction. Commodity futures prices are continuously available through data providers such as Bloomberg, Reuters, and Dow Jones. Futures markets are regulated both by a government agency - the Commodity Futures Trading Commission (CFTC) - and by a self-regulatory organization - the National Futures Association (NFA).

Although futures trading in many tangible commodities dates back to the nineteenth century, it wasn’t until 1972, when the Chicago Mercantile Exchange introduced the first financial futures, that commodities became of interest to securities professionals. Their understanding of the commodities markets led to burgeoning trading activity in non-financial contracts as well. In 2004 over $12 trillion in value of tangible commodity futures traded in US dollar-denominated contracts.

Gaining Exposure to Commodities

The marketplace offers investors several ways to gain exposure to commodities. These include:

• physical commodities,
• natural resource stocks or funds,
• managed futures funds,
• commodity indices, and
• diversified commodity funds (DCF’s).

We believe that DCF’s are the optimal choice for investing in commodities as an asset class. The alternatives bear the following disadvantages:

• Physical commodities. Owning physical commodities provides exposure to the asset class. But issues such as purchase, location, storage, grade, seasonality, spoilage and disposition are complicated and make this method impractical even for a single commodity, let alone a broad spectrum.
• Natural resource stocks. Factors other than commodity prices, such as competition and the uncertain success of strategy execution by the management of the company, affect returns.
• Managed Futures accounts or Commodity Trading Advisors (CTA’s). Approximately 75% of CTA funds invest in financial futures rather than tangible commodity futures. In addition, they may be both long and short, as well as leveraged. This means that the investor might not be getting the expected exposure to commodities. Finally, we believe that investors should not have to pay incentive fees for asset class exposure.
• Commodity indices. Investing in a commodity index or index future will provide sufficient asset class exposure. However, index managers have no incentive to trade skillfully and, if the investment is in an over-the-counter (OTC) vehicle such as a swap, the investment may be taxed at short-term rates. Finally, published rules for roll conventions provide information to traders on the floors of commodity exchanges that lets them anticipate the index’s actions.

Diversified commodity funds (DCF’s) offer the benefits of a commodity index strategy and the flexibility in structure that allows the manager to maximize the various components of total return (detailed below). In addition, there is potential for tax efficiencies in owning futures rather than OTC vehicles.

Return Components of a Diversified Commodity Fund

The total return on an investment in a DCF depends on the following elements:

• Commodity selection: Methodology for selection of commodities and their weightings;
• Trade execution: Market impact of trades;
• Collateral enhancement: Managing the return on futures contract margin excess (typically about 90% of futures contract value);
• Roll management: Futures contract roll implementation; and
• Rebalancing methodology: What methodology determines when the portfolio is brought back to the intended proportions.

In the total return of Gresham’s Tangible Asset Program™, about

• 44% of the return has come from the price movement of physical commodities (commodity selection, rebalancing methodology, and trade execution);
• 42% from the return on collateral (90-day US Treasury Bills); and
• 14% from the roll yield, though these percentages may vary in the future.

The methodology and implementation of TAP^® is more fully described in the next section.