Inflation risk is very much a known unknown. It’s not a question of whether inflation will rise, but rather when, in developed markets. Admittedly, the UK recorded a fall in inflation to 2.4 per cent in April. But from a longer-term perspective, inflation is something that investors should be thinking about and planning for.
One way to protect against inflation risk is through commodities. These aren’t exactly flavour of the month right now with investors favouring riskier asset classes like equities. But as Jeremy Baker (pictured), senior commodity strategist at Harcourt Investment Consulting, states: “The trend in commodity prices recently has not been too favourable but one could argue that there is still a structural bull market in China and inflation in the West is a long-term issue. I would not be recommending clients to shift their allocations into equities given the rise in markets we have seen since last November. Personally I would be advising them to look elsewhere for value, which I believe still exists in the commodity markets.”
Harcourt runs two actively managed commodity funds: Vontobel Fund – Belvista Commodity and Vontobel Fund – Belvista Dynamic Commodity. The latter has the ability to use leverage and take short positions, the former is more of a standard smart beta-type product. Both use the DJ-UBS Commodity Index as their reference benchmark.
Part of the way that the commodity portfolio managers at Harcourt build the risk profile is through specific sector deviations relative to the benchmark. These vary for each sector within the portfolio and are based on the underlying liquidity. This then helps determine how much the fund can deviate away from the benchmark through being actively underweight or overweight in its positions.
“The further along the curve you go the less liquidity there is. A front-month contract has good liquidity, but if you look at say the sugar market 18 months out, it is a different thing altogether. Liquidity and open interest within individual commodities are important factors in managing risk in the fund.
“In addition, we look at size limits versus the benchmark. We have specific sector limits which are then broken down into individual commodity contract limits. Let’s consider crude oil: what we could do there is deviate from the benchmark by plus or minus 7.5 percent. That could also apply to soybeans, copper, natural gas,” explains Baker.
Given that both funds offer daily liquidity, it is vital that the fund does not get caught out in a market where liquidity suddenly dries up. Taking this sector-by-sector approach to determine the level of deviation makes for a highly flexible risk management process.
As Baker continues: “We use a structured and disciplined investment process. Position risk is managed on a pre-emptive basis. We are looking to maximise the alpha from our positions but we always monitor the VaR and tracking error of each commodity contract versus the benchmark itself. We look at standard risk measures, analyse the volatility and correlation of individual commodities as well as ex ante monitoring to determine relative VaR. We then use this to determine the risk within individual commodities and individual sectors.
“What we have found historically is that VaR risk tends to sit in one particular sector, and within a few commodities within that sector, so we know exactly where the risk sits and how to manage that risk within the portfolio.”