The Financialization of Commodities

How market dynamics have changed...

MIKE NORMAN of Hard Assets Investor talks to MA Capital Management's chief marketing officer Zina Spezakis about investing and market psychology.

Mike Norman, Hard Assets Investor (Norman): My guest today is Zina Spezakis of MA Capital Management. Zina, welcome to the show.

Zina Spezakis, chief marketing officer, MA Capital Management: Thank you.

Norman: Tell us a little bit about your approach to the markets. I know it's quantitative, what you do, and it covers the broad spectrum of equities, commodities, etc.

Spezakis: Basically we're a systematic shop, which means that most of our investing is based on model-driven decisions. And we cover everything from plain-vanilla equity bonds to more alternative assets including commodities, real estate and some hedge funds, systematic hedge funds.

Norman: Now, how has the growth of interest in commodities affected your approach, or your portfolios that you manage?

Spezakis: That's an interesting question and a good one. The answer's not so simple. So commodities, as with a lot of asset classes, have gone through some interesting changes in the last few years, and with the advent of financialization. So a lot of these products have been put into ETFs, where now mom-and-pop investors have access to them. 

That should essentially change the dynamics in the market. And studies have shown that buying commodities through an index, that sort of financialization of commodities has changed correlations between commodities, and also between commodities and other assets such as equities.

So that's something that our models adapt to, because correlations over time obviously change and so must your portfolio management. But it's something that investors need to be aware of, that some of these correlations have changed, and they're increasing.

Norman: Now, how have they changed? To me it seems like there's more of a one-way-bet element going on here. I'll bring up one example—the involvement of large institutional passive investors, the long-only investors, pension funds, endowments that now want to hold commodities as an asset class. And they're not really playing both sides of the market. They just want to have some percentage of commodity exposure. They're basically playing the long side. When you talk about changing your model or adapting it to this new paradigm, isn't it more of a long-only bet now?

Spezakis: Well, commodities traditionally have been used by larger institutions, and those have been the players. But what indexation and financialization of them have created is there are many different types of players now. And so commodities—at least the ETF prices, for example—are not necessarily so much a function of supply and demand as they're also starting to be influenced by the sort of relative supply and demand of different assets in the market.

So in the pension plan, some wealth funds, these large investors, global money supply in general has increased. So we see a lot of these investors chasing yields. They want to make money just like anybody else. And holding it in a savings account, you're losing money if you're sort of measuring it against inflation.

So we believe that because there are all these changes, and nobody knows what the next change is going to be, investing needs to actually be adaptive. And you need to be aware of not only what asset prices are doing, but how they're acting versus each other.

Norman: So it's interesting that you say the commodity markets are sort of becoming divorced from supply and demand fundamentals. That to me seems like a bad distortion. You could actually have, for example, a situation where you have an abundance of something—let's say gasoline or corn—and prices are going up. This makes it obviously negative for consumers. It also makes it negative for hedgers. And we've seen examples of this where a farmer who historically understands hedging and how to apply it, now he's short his crop. And the prices just keep going up and then he can't get financing to roll that short over.

Spezakis: And that's part of the reason regulators have sort of played with the idea of putting constraints on investing in these ...

Norman: You think that's good?

Spezakis: I generally don't think constraints are a good thing, and I want to believe that the market knows in the long term what it's going to do.

Norman: So if we drive, we should just be able to drive as fast as we want to; go 100 miles an hour in a school zone?

Spezakis: Well, the corollary to that is that you're not necessarily going to be driving at 100 miles an hour in a school zone because you're going to have a moral sort of obligation to not run over the grandmother crossing the street. I think regulations need to be smart. The problem with a lot of regulations, at least in my opinion, has been they've been one or two steps behind  financial innovation.

And it's a cycle that keeps repeating itself. And whether there's going to be an end to that cycle, who knows? But getting back to investing and your average investor—whether it's a hard asset investor or anybody else—markets are constantly changing, correlations between assets are constantly changing. And so basing your investment on something that happened in the past that might no longer be applicable might not be the best way to go.

Norman: That's interesting, because in creating your model, you obviously have to have a set of data and make assumptions based on that. So past performances aren't an indication of ... is that what you're saying? I'm not asking you to divulge what goes into it. And you're saying it may change again. How do you know? What do you look at? What are the signs?

Spezakis: You don't really know what the future is going to hold. So the best thing to do is have really robust risk management measures in place, and whether that is risk management measures that look at short-term trends, or risk management measures in addition to short term that look at longer-term trends.

It's the buy-and-hold sort of model. In the last 10 to 15 years, if you had nerves of steel, you probably have done OK. If you stayed invested during the dips, you recovered most of your assets. But if you look at equity, mutual fund flows, people sell low and they're constantly buying high.

Norman: It's the behavior that kills us.

Spezakis: It's the behavior. So what's that driven by? That's driven by panic and greed, essentially.

Norman: And human emotion.

Spezakis: Human emotion.

Norman: You want to take that out.

Spezakis: The economic models are really based on rational decision-making. And that rational decision-making isn't necessarily in the market. So your money manager, whoever's managing your money—you should really understand what kind of risk management measures they have in place.

So if they see factors that may affect bond prices, they should make a change to or from their bond allocation. So it's looking less at the individual securities, and looking more at asset classes, and managing the risks around those asset classes.

Norman: What would you say to an investor—and we hear this a lot lately—"You must own gold. You must own gold for the long term." You just said that buy-and-hold strategy, over time it doesn't work very well. What would you say to them?

Spezakis: I would say to them, if you can buy and hold and be completely rational that might not be ... whether it's gold or any other asset class, now versus 50 years from now, if asset prices haven't increased, there's something wrong with the planet. But it's that variation that, if you can't stand that volatility, buy-and-hold really needs to be enveloped in a robust risk management process.

So when investors ask me, "Should I jump out of the market? Is it getting too risky, or should I go back in? What's happening, Zina?" My first question to them is, "Can you stomach what happened in 2008/2009? Are you going to be a seller when the market drops? Are you just going to sit there, or are you going to be more aggressive?" So it really comes down to the risk appetite of an individual. There are very few investors I have found, despite what they tell me, who are aggressive risk takers.

The vast majority of people will panic. And you see that, and the data proves that out. Because if you look at mutual funds flows, they peak at market tops.

Norman: Right. And they all bail out at the bottom; everybody should be doing the opposite.

Spezakis: And the chart just does not change, if you just look at that. The data is really interesting just to look at that.

Norman: It is interesting, because I've always said, in terms of behavior—and especially when you look at the United States—we invented discount shopping. No other country on earth goes at it with the penchant that we do. We don't buy anything unless it's on sale, right?

Spezakis: It's a sport.

Norman: Exactly. But yet when it comes to investing, people do the exact opposite: They buy when prices are high and then they sell when prices are low.

Spezakis: I'll tell you something, Mike, it actually is driven almost by the same emotion. If you're going into a Walmart or into a Costco, whatever, and you're buying stuff, you're excited about it, right? And so you're piling more money into ... people would argue that gambling is the same thing. But with investing, you don't want to miss the boat. You don't want to be the last person in your group of friends that isn't in the market.

It's interesting; there's always red flags with bubbles. And during the last bubble, I had a lot of my mom's older retired friends who have barely had savings accounts or CDs say, "I think I should be buying the market." That right there is a clear sign of emotions; that is not decision based on any sort of analysis. That is not a decision based on even looking at their own circumstances. It's a greed response. And the same thing on the downside.

Norman: Like the magazine cover indicator.

Spezakis: Exactly.

Norman: Zina Spezakis, thank you very much. Fascinating, very interesting.

Spezakis: It was a pleasure, Mike.

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