Investors look to complex, proprietary commodity indexes for solutions

By Emma Trincal

New York, June 10 - Demand for commodity products linked to rules-based, proprietary and complex indexes is strong, even among retail investors, sources said. Appetite for the underlying asset class remains unabated despite signs of a global economic slowdown.

Banks, seeking to increase their market shares, have been selling notes linked to algorithmic commodity indexes created to solve some of the problems investors face when investing in competing products such as exchange-traded funds, sources said.

Curve slope

Indexes continuously roll futures contracts since delivery is not an option. But in this process, a problem, called contango, can arise when the cost of rolling the futures increases, which happens when the longer-dated contracts that must be bought are priced higher than near-dated contracts that must be sold, explained Steve Doucette, financial adviser at Proctor Financial.

"A lot of these indexes are set to minimize contango; that's the whole concept," he said.

"With an ETF, you subject yourself to the risk of contango, which erodes returns. Those indexes are for the most part a way to eliminate that risk."

Recent deals

From April 1 to June 3, U.S. agents priced $2.99 billion of commodities notes, including exchange-traded notes. Among those, $1.73 billion, or 58%, were based on complex, algorithmic commodities indexes, according to data compiled by Prospect News.

Two of the top three deals in the first week of June were algorithmic-based, the data shows.

Among them, Deutsche Bank AG, London Branch priced $20 million of 0% market contribution securities due June 5, 2014 linked to the Deutsche Bank Liquid Commodity Index - Mean Reversion Enhanced Total Return.

Bank of America Corp. priced $13.94 million of 0% Accelerated Return Notes due June 18, 2012 linked to the Merrill Lynch Commodity Index eXtra - Excess Return index.

The Merrill Lynch Commodity Index eXtra is a rules-based index that offers a different roll schedule for the commodities contracts as a way to optimize rolling.

The Deutsche Bank Liquid Commodity index systematically adjusts the weights of the commodities in the index based on their relative prices.

Beta series

Another popular index recently has been the J.P. Morgan Contag Beta Alternate Benchmark Class A Excess Return index, which JPMorgan Chase & Co. used as underlier when it priced $20 million of 0% daily liquidity notes due May 22, 2014.

The index aims to select the futures contracts with the lowest level of contango on the futures curve.

In April, Barclays Bank plc announced the listing on the NYSE Arca of 18 new commodity iPath ETNs linked to Barclays Capital Pure Beta indexes.

The bank registered to sell up to $1.6 billion of the ETNs.

The Pure Beta technology was also designed to mitigate some of the negative roll that may occur on the futures curve. It is designed to give investors exposure to the S&P GSCI Total Return index. But unlike the S&P GSCI index, which rolls contracts monthly according to a pre-set schedule, the Beta index rolls them into varying future dates following a rule-based approach designed to limit price distortions, according to a bank press release.

Diversification

Some of the underlying indexes offer benefits other than just limiting negative roll such as increasing diversification, designing volatility plays or improving sector weighting based on price movements.

For instance, Royal Bank of Canada just announced its plans to price 0% commodity-linked notes due Dec. 29, 2017 linked to the BNP Paribas Oscillator Commodities Target Volatility 8 USD Excess Return index.

The index consists of up to 19 commodity indexes each based on rolling individual commodity futures contracts and not on the spot prices of the underlying commodities. The 19 portfolio components are diversified across four different asset classes: energy, base metals, precious metals and agriculture. The payout at maturity will be par plus the index return, subject to a minimum payout of par.

Another factor behind the popularity of those proprietary indexes is recent market developments.

Following the commodity sell-off in May, investors are turning away from single-commodity bets, a sellsider said.

"People don't really have a clear idea about what commodity to invest in," he said.

"Rather than picking oil, agriculture or metals on their own, they play the diversification card."

Despite the complexity of the underlying algorithmic indexes, he said, retail investors are the most likely to invest in those products.

"They don't have the choice. Those deals come from the private banks that follow an asset allocation model. Retail investors just buy what they're being told to buy," he said.

Active management

Being able to invest in a more dynamic structure is also a strong motivation for investors, a financial adviser said.

"I don't think these deals are in demand because people want to address contango. Rather I think it's because people are looking for a little bit more of active risk management," said Matt Medeiros, president and chief executive officer of the Institute for Wealth Management.

"A typical structured note would have from a structural perspective inherent rules that don't allow for active management. Most of the notes have a static basket that doesn't reset.

"An algorithm is based on metrics that allow for a rebalancing mechanism embedded in the note. That's what the black box does.

"I don't know if it's easy to understand the algorithm even though it's in the prospectus. But the sales benefit really is the ability to actively rebalance your portfolio with the algorithm.

"It's a benefit to both retail investors and institutional investors."

But a market participant said that the deals are too complex to be embraced by retail clients.

"For sophisticated investors, family offices, it would make a lot of sense as a hedge," he said.

"But with all the moving parts, I think it would be a stretch for retail investors."

"It all boils down to doing your due diligence on the underlying and looking at the performance," Doucette said.

"There are many algorithmic indexes in commodities, and they can easily be used for all kinds of views.

"If you're bearish on commodities, you can use them with a little bit of a protection built into it.

"There are a lot of opportunities to play the commodities space and to minimize some of the volatility of this asset class. And that's the beauty of it."

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