Capitalizing on the Commodities Market despite Extreme Volatility - Presentation: Michel Toupin, Laval University Pension Fund - Canadian Institutional Investment Summit

Canadian Institutional Investment Summit

« CAPITALIZINGON THE COMMODITIES MARKET
DESPITE EXTREME VOLATILITY »

GUEST SPEAKER :
MICHEL TOUPIN, MANAGING DIRECTOR
FONDS COMMUN DE PLACEMENT DES RÉGIMES DE
R E T R A I T E D E L ’ U N I V E R S I T É L AV A L

October 17-19, 2011 - Hilton Lac-Leamy,
Gatineau-Ottawa, Quebec

ORDER OF PRESENTATION
2

 GENERAL OBJECTIVE

 PENSION FUNDS OBJECTIVES AND PROCESS

 COMMODITIES PORTFOLIO
 A transfer of risks
 Some indices
 An inadequate substitute, regional consideration
 A risk-reward perspective

 CORRELATIONS ANALYSIS

 IMPLEMENTATION

 A GLOBAL PERSPECTIVE – DEMOGRAPHY AND URBANIZATION

 OTHER CONSIDERATIONS AND CONCLUSIONS

Canadian Institutional Investment Summit Oct. 2011

PRESENTATION - GENERAL OBJECTIVE
3

 « To describe a commodities portfolio and to
introduce its benefits for a pension fund .


PENSION FUNDS
OBJECTIVES AND PROCESS
4


COMMODITIES AND PROTECTION
5

 Two combined strategies

« to provide a protection against inflation and its
effects upon the liabilities as well the assets, no
matter the source of inflation» (considering the
commodities as a potential source)

« to reduce the global risk through a more
efficient diversification »


COMMODITIES – « THE ORIGIN »
A case : Laval University Pension Funds
6


COMMODITIES FOR INSTITUTIONAL INVESTORS -
A SPHERE OF INFLUENCES IN 2011
7


THE COMMODITIES MARKET
A TRANSFER OF RISKS BETWEEN PLAYERS
8

hedging

Bond Holder Speculator-Arbitragor-
Hedge Funds

Commodity
Final sales Transformer-Final User
Producer

Shareholder Diversified Investors

hedging investing

TWO COMMODITY INDICES
AND THEIR CONTENT
9


10

REGIONAL
CONSIDERATIONS AND
OPTIMISATION


AN INADEQUATE SUBSTITUTE (1)
11

• Question : Can we replace a Commodity Index (such as The
Goldman Sachs C. Index) with Canadian Stocks?
• Answer : No

1. Correlation between 4 sectors or sub-sectors of the TSE 300 and
the GSCI: Mines and Metals, Gold and Precious Metals, Oil and Gas and Pipelines versus Goldman
Sachs Index (all sectors)

• Result :
to have the best correlation TSE 300/ GSCI = 0,41 the model
keeps only Mines and Metals (TSE300), rejects others
2. Correlation between the TSE 300 (all sectors) and the GSCI :
maximum correlation = 0,42, the model keeps only Oil and Gas
and Gold Precious Metals (TSE300), rejects others

Canadiani Institutional Investment Summit Oct. 2011

AN INADEQUATE SUBSTITUTE (2)
12

• Correlation between the TSE 300 (all sectors) and the GSCI -
Energy :
maximum correlation = 0,49 between the TSE 300 and the
GSCI, the model keeps 1 sector of the STX300, Oil and
Gas;

Finding:

We tried to replicate, from a canadian
perspective, the market behaviour as defined by
a commodities index but, we failed.

What’s a possible explanation ?

CHOOSING BETWEEEN COMMODITIES AND STOCKS
A CASE : IShare Commodity Index and Chicago Mercantile
Exchange Group (the stock)
13

Difference = Business or “Non-
Systematic” Risk ?

I Share Commodity Index

CME Group
-25%

-35%


CORRELATION ANALYSIS
( Q U A N T I TAT I V E P R O C E S S )

14

HOW TO DETERMINE THE
PROPORTION, APPROPRIATE V E R S U S
ACCEPTABLE


RISK-REWARD ANALYSIS
SIMULATION WITH SIX MARKET INDICES
15

Index Expected
Rendement Rendement au Rendement au
Indice espéré
return
Ranking 90 th
90ième rang Ranking 10 th
10ième rang
centile centile
Goldman 8,4% -14,9% 26,4%
Commodities
MSCI EAFE 9,4 -12,8 28,6
S&P 500 17,5 -0,2 34,9
TSE 300 3,6 2,4 4,8
SMc Univers 7,7 -0,8 14,8
Russell 2000 14,2 -8,0 35,7

Close to worst Close to
median median

January 1992 to December 2000, Cdn $.


ADDING COMMODITIES
A RISK-REWARD OPTIMIZATION
16

Matières Matières Matières Matières
premières = premières = premières = premières =
0% 2% 6% 8%
Commodities = 0% 2% 6% 8%
Rendementreturn
Expected
espéré 4,6% 4,6% 4,6% 4,6%
95ième rang centile
-3,6 -3,4 -3,0 -2,8
Probabilité
Probability of
d’échec ( sur 3 ans 19,4 17,8 16,3 15,7
missing the MAR
r.min=0%)
Rendement
baissier espéré -2,7 -2,6 -2,4 -2,3
(r.moy sous 0)

Titres de
Stocks
participation 55,0 53,0 49,0 47,0
(1/3, 1/3, 1/3)
Bonds
Titres d’emprunt
(1% mm et 44% obl.) 45,0

Les rendement sont exprimés en termes réels

CANADIAN AND FOREIGN STOCK MARKETS
COMPARED VOLATILITIES
17
R a n g e o f R e t u r n s f o r 3 In v e s t m e n t C a t e g o r ie s
J a n u a ry 1 9 8 8 - A u g u st 2 0 1 1
R e tu r n Legend
3 0 .0 % H i g h e s t:
2 8 .0 %
2 6 .0 %
2 4 .0 % 2 3 .0 % 2 3 .3 %
2 2 .0 %
2 2 .0 %
2 0 .0 %
1 8 .0 %
1 6 .0 %
1 4 .0 %
1 2 .0 %
1 0 .0 %
8 .0 %
6 .0 %
4 .0 %
2 .0 %
0 .0 % A v e ra g e :
-2 . 0 %
-4 . 0 %
-6 . 0 %
-8 . 0 %
-1 0 . 0 %
-1 2 . 0 %
-1 4 . 0 %
-1 6 . 0 %
-1 8 . 0 %
-1 7 . 9 %
-2 0 . 0 %
-2 2 . 0 % COMMODITIES -2 1 . 1 %
-2 4 . 0 %
-2 4 . 2 %
-2 6 . 0 %
-2 8 . 0 %
-3 0 . 0 % L o w e s t:
S&P GSCI TR CAD M S C I E M A sia U S D S & P /T S X E n e rg y T R


ALTERNATIVE PORTFOLIOS
COMMODITIES VARYING FROM 0% TO 50%
18
R E LAT IV E S P E R FO R M AN C E S AN D R IS K S
De ce m be r 1999 - De ce m be r 2010
R e tu rn (A M )
0 .9 %

Alternative portfolios
0 .8 %

• (% of total port.) 1 2 3 4 5 0 .7 %

50% COMMODITIES
• Commodities 16,7 0 20 25 50 0 .6 % 1
P o rtfo lio (5 )
0 .5 % P o rtfo lio (4 )
• Large Cap. US 20 20 25
• (Russell 1000) 0 .4 % P o rtfo lio (1 )

P o rtfo lio (2 )
• MSCI EAFE 20 0 0 .3 %
P o rtfo lio (3 ) NO COMMODITIES
0 .2 %
• Large Cap. Can. 0 25
• (S&P/TSX 60) 0 .1 %

• DEX Real Retrn. 20 25 0 .0 %

-0 .1 %
• DEX All Gov. 20 0 50 1 .0 % 1 .3 % 1 .6 % 1 .9 % 2 .2 % 2 .5 % 2 .8 % 3 .1 % 3 .4 % 3 .7 % 4 .0 % 4 .3 % 4 .6 % 4 .9 % 5 .2 % 5 .5 % 6 .0 %

R isk (S T D )


COMMODITIES –INFLATION AND INTEREST RATES
WHO COMES FIRST ?
19

Consumption Wars, Catastrophes, OPEC
Demand Offer

Oil Other
Products

GSCI Commodity Index

MONETARY Inflation US
POLICIES
US Interest rates

Inflation CDN

Canadian Interest rates

Real estate Real Return Bonds


COMMODITIES AND INFLATION
CORRELATION FROM 1996 to 2011
20

Correlation Rolling Period 24 M onths
C o rre la ti o n V a lu e s
80.0%
75.0% 76.3%
70.0%
65.0%
60.0%
55.0%
50.0%
45.0%
40.0%
35.0% FINANCIAL CRISIS
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
De c De c De c Ju n
1996 2000 2005 2011
I n te rv a l : 2 4
S & P G S C I T R v s. IA S B B I U S In fl a tio n

MATURE PENSION FUNDS
PARTICULAR NEEDS
21

 Constraints
 An urgent need to finance or match the annuities adjusted for
inflation ;

 Strategy (depending on each pension fund)
 Matching inflows and outflows in terms of :
 Dollars matching,

 Sensibilty to market movments,

 Timing of entry-exit, perfect synchronisation when
implementing


22

COMMODITIES AND
IMPLEMENTATION ISSUES


PORTFOLIO IMPLEMENTATION
THE BEST IS HAVING GOOD TIMING…. (easy to say !)
23


COMMODITIES AND THE CURRENCY EFFECT
TO AVOID A « ZERO-SUM GAME » BECAUSE OF AN APPRECIATION
OF THE CDN $
24

COMMODITIES

profits

losses
CANADIAN DOLLAR


AFTER IMPLEMENTATION OF COMMODITIES
VARIOUS CORRELATIONS
25
C o r r e la t io n R o llin g P e r io d 6 0 M o n t h s ( C D N $ )
C o r r e l a ti o n V a l u e s
6 0 .0 %
5 8 .0 %
5 6 .0 %
5 4 .0 %
5 2 .0 %
5 0 .0 %
S&P/TSX60 TR
4 8 .0 %
4 6 .0 %
4 4 .0 % 4 4 .2 %
4 2 .0 %
REAL RETURN BONDS
4 0 .0 %
3 8 .0 % 3 8 .2 %
3 6 .0 %
3 4 .0 %
3 2 .0 %
3 0 .0 % 2 9 .4 %
2 8 .0 %
2 6 .0 %
2 4 .0 %
2 2 .0 %
2 0 .0 %
1 8 .0 % 1 7 .4 %
1 6 .0 %
1 4 .0 %
1 2 .0 %
1 1 .0 %
1 0 .0 %
8 .0 %
6 .0 %
4 .0 %
2 .0 %
0 .0 %
-2 . 0 %
-4 . 0 %
-6 . 0 %
-8 . 0 %
-1 0 . 0 %
-1 2 . 0 %
-1 4 . 0 %
-1 6 . 0 %
-1 8 . 0 %
FINANCIAL CRISIS
-2 0 . 0 %
Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Aug
2004 2005 2005 2005 2005 2006 2006 2006 2006 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011
In te r v a l: 6 0
D J U B S C o m m o d i ty T R U S D v s. R u sse l l 1 0 0 0 T R U S D D J U B S C o m m o d i ty T R U S D v s. M S C I E A F E U S D
D J U B S C o m m o d i ty T R U S D v s. S & P / T S X 6 0 T R D J U B S C o m m o d i ty T R U S D v s. D E X R e a l R e tu r n B o n d T R
D J U B S C o m m o d i ty T R U S D v s. D E X L T A l l G o v e r n m e n ts T R


AFTER THE IMPLEMENTATION
A PERPETUAL MONITORING
26

 YEAR 1 : Two managers, same index : GSCI
Core, index approach
 YEAR 4: One manager, one index : GSCI Light
Energy (agriculture under represented)
 YEAR 7: New manager (3rd) : Dow Jones, more
“balanced”
 Fees less than 30 pb, no incentive,
 Continual challenge : strict discipline


DEMOGRAPHY AND
URBANIZATION
27

A GROWING DEMAND FOR
COMMODITIES


WORLD GROWTH AND DEMOGRAPHY
POPULATION OF “LDC’S” INCREASES BY 50%
28

100%

Source : United Nations


URBANIZATION AND POTENTIAL DEMAND
FOR COMMODITIES
29

Source : United Nations


OTHER CONSIDERATIONS
AND CONCLUSIONS
30


A FIDUCIARY PERSPECTIVE
31
 Pros’  Cons’
 A proven diversification  Source of nervosity or source of
tool exuberance
 Test your capacity to maintain
 Technical factors discipline while assuming your
 No default risk, clearing choice (decided allocation and
house indexing, if any)
 Extreme liquidity  The investment is original and
rapidly appear a conflict
 Efficient if you manage between prudence and the
adequately the collateral optimal allocation to maintain


COMMODITIES AND CURRENT YIELD
A CHALLENGE FOR MATURE PENSION FUNDS
32

• Bet on the performance instead of the current yield ;
– Commodities : generate a pretty weak yield from the money
market, the price appreciation makes the difference :

– Real estate : generate positive cash-flows on a monthly
basis, the cash-flows may be indexed depending on the sector ;

– Real return bonds : generate a series of coupons fully indexed
with a possible capital appreciation.


COMMODITIES
DIVERSIFICATION TOOL
33

 The « tolerance point » is intuitive and seems to be around 10% of
the total portfolio although…

 The « optimal point » may reach » up to 25% of the total portfolio
(rarely seen…);

 A target around 8% is a risk-reducer which keeps constant the
performance of the total portfolio;

 The real value behind commodities is its weak correlation with
traditional invesments. Caution : the « ups’ and downs’ are
frequent and may be important.


COMMODITIES – LITTLE-KNOWN ASPECTS
A COMBINATION OF CHALLENGES
34

LUCK TO
INTRODUCE
THE
PRODUCT
(YOU NEVER
KNOW WHEN)

DISCIPLINE TO
MAINTAIN THE
PRODUCT RATIONAL AND
(IN ADVERSE MEMORY TO
CONDITIONS) JUSTIFY THE
PRODUCT
(DIVERSIFICATION
VERSUS
SPECULATION)


CONCLUSIONS
35

 Since we measure our performance
attribution, commodities added up to 40-50 pb. To the total
performance
 You should consider to hedge the US position on
commodities, our hedge ratio is 50% of the US exposure
(based on a frequent evaluation of the market value)
 Ask your consultant to :
 Identify the “good” index, test more than one ;
 To do not try to time the market when implementing and
after and,
• Remain indexed until you feel comfortable with the asset
class


Capitalizing on the Commodities Market despite Extreme Volatility - Presentation: Michel Toupin, Laval University Pension Fund - Canadian Institutional Investment Summit

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Capitalizing on the Commodities Market despite Extreme Volatility - Presentation: Michel Toupin, Laval University Pension Fund - Canadian Institutional Investment Summit