Barclays uses enhanced strategies to help commodity-linked investors navigate contract rolls

By Emma Trincal

New York, Oct. 16 - Performance hits to commodity-linked notes from the costs of rolling the underlying contracts have prompted Barclays Capital to create new approaches to using indexes.

Investors in commodity-based structured notes may lose money when facing a negative roll yield or when the cost of a near term futures contract is higher than the later delivery contracts, a phenomenon called contango.

Philippe Comer, head of commodities Investor Solutions, Americas at Barclays Capital said that his bank has been designing new index strategies in an effort to counter the negative impact of contango.

"A lot of our clients are alleviating this possible contango issue in getting long positions in forward contracts via enhanced strategies," said Comer. "They are getting more and more knowledgeable and are increasingly aware of the cost of carry involved with rolling futures contract in contangoed and backwardated markets."

Cost of rolling

Noteholders who invest in products tied to commodity indexes see their performance subject to the costs of rolling the underlying futures contract. The index algorithm rolls futures contracts on an ongoing basis in order to avoid physical delivery, selling contracts that expire now and buying further delivery contracts, which expire at a later date.

When the rolling curve is in contango, nearby contracts are cheaper than contracts further out on the curve. As a result, the index sells the nearby contracts low and buys at a higher price the contracts that expire at a later date.

The result is a rolling process that has become more expensive, with the additional cost negatively impacting the index performance, and so the returns of commodity-linked notes. The opposite market condition to contango is called backwardation.

In order to protect investors from contango, Comer said that Barclays has been using three different strategies.

Deferred strategy

He described the first one as the deferred strategy under which Barclays uses forward benchmark indexes.

Instead of rolling the nearby contract, the approach takes a long position on a point further in the future, for instance by rolling the three-month forward contract across the whole basket, said Comer. He added that this strategy can be employed using commodity benchmarks such as the Dow Jones-UBS commodity index or the S&P GSCI; both offer forward sub-indexes that track longer-dated commodity futures, such as the three-month forward index.

Comer gave an example. Today, in mid-October, an investor using a conventional strategy would have exposure to the November contract. In the middle of November, that investor would start rolling his November contract into December. In contrast, using the deferred index strategy, an investor would be invested today in the January contract. And at the end of October, the same investor would be selling the January contract and buying the February contract.

"This deferred strategy is one way to lessen the impact of contango," said Comer. Comparing the curvature at the Nov/Dec contracts and the Jan/Feb contracts, the front part of the curve is steeper, Comer said. Investors may reduce the cost of rolling by moving further out on the curve, he said.

"But the problem with this strategy is that it's static. You always allocate to the same point on the curve," said Comer, who added that Barclays came up with a second strategy precisely designed to solve this issue.

Dynamic allocation

In September 2007, Barclays launched its Dynamic Enhanced Beta strategy, which uses a dynamic allocation across the curve.

"For each commodity in the index, this strategy uses an algorithm that will find the most adequate position in the curve," said Comer. "The benefit of the dynamic allocation is that it allows you to have your allocation react to the yield curve. You're not always stuck at some point in the curve."

Comer said that when making the allocations to each commodity composing the index, the algorithm may find that for instance the best allocation for crude oil would be this month while copper could be on the six-month contract.

The Dynamic Enhanced Beta strategy is reviewed quarterly. Investments can be made in any point in the curve up to one year.

Long/short ComBATS

Last year, Barclays improved this dynamic allocation strategy and created a new product using the same methodology but designed to produce market neutral returns. It called it ComBATS.

The strategy continues to help investors alleviate some of the rolling costs as it takes a long position on the pure beta methodology or other enhanced strategies offered by Barclays. But in addition, the strategy takes a short position in the front end of the DJ UBS commodity index.

"This alpha strategy enables you to extract the performance of the enhanced beta strategy without having the exposure to commodities," said Comer. "It's market neutral. You get stable returns and low volatility. "

In theory, investors in commodities that are in contango incur a cost and those in backwardation see a gain. But in reality, things may be more complex, as explained Comer.

"The ComBATS strategy can be particularly attractive when the curve is in contango but not automatically," said Comer. "What we look at is the relation between the front and the back of the curve. For instance you can imagine situations where backwardation in the front end of the curve is not as great as in the back. What matters is the relation between the two maturity points of the curve. As long as forward backwardation is more than backwardation in the front end of the curve, you benefit from backwardation," he said.

ComBATS has generated a 10% annualized return with 3% to 4% volatility since its inception in March 2008, said Comer.

Comer said that enhanced commodities strategies work for investors who want a long exposure to commodities for various reasons - as an inflation hedge, for protection against dollar depreciation and for asset diversification - while seeking to reduce the volatility of their commodity exposure.

"ComBATS has been adopted by institutional investors. Our goal is to give wider access to this strategy via different vehicles," said Comer.

He noted that "for greater appeal the long/short strategy may be delivered in principal protected format."

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