Bache Commodity Long/Short Index 2010 Annual Review
Table of Contents Performance Summary 1 Sector Analysis 2 Contribution of BCLSI Return Factors 3 Changes to the Long/Short Index Methodology 3 Commodity Outlook for 2011 4 Appendices BCLSI Component Weights 2010 2011 5 BCLSI Total Returns 1991 2010 5 Disclosure 6 New York Sales and Marketing Laryssa Temnycky laryssa.temnycky@bache.com Tel. 212.778.1091 Mitzi Noma mitzi.noma@bache.com Tel. 212.778.4205 London Sales and Marketing Simon Smith simon.smith@bache.com Tel. +1 44 207.548.5110 Marc Fisher marc.fisher@bache.com Tel. +1 44 207.548.5110 Head of Commodity Asset Management Rupert Allan rallan@bache.com Tel. 212.778.1855 www.bache.com
The Bache Commodity Long/Short Index Built for Investors Seeking Dynamic Commodity Exposure The Bache Commodity Long/Short Index BCLSI is an absolute return index, which provides investors broad-based, long/short commodity exposure to nineteen commodities across the Energy, Metals and Agricultural Sectors. The Bache Commodity Long/Short Index utilizes the BCI methodology, which is a proprietary approach developed to combine the benefits of transparency, liquidity and risk-reduction while providing additional sources of return beyond the commodity beta offered by traditional commodity indices. The Bache Commodity Long/Short Index extends the strategy as it seeks to generate alpha in both up and downward-trending commodity markets while capping short positions to mitigate risk and maximize risk-adjusted returns. Summary Invests in exchange-traded futures contracts, offering both transparency and liquidity. Sets maximum allocation targets to preserve broad diversification. Reduces transaction costs through a proprietary transaction minimizing strategy. Provides multiple sources of return and volatility control by combining four return factors: Dynamic Asset Allocation The algorithm-based model increases commodity exposure when prices are rising and reduces exposure or establishes short positions when prices are in decline. The model employs clearly defined rules, which control the maximum long and short levels of exposure by sector and by individual commodity, seeking to capitalize on return opportunities presented by short-term momentum and long-term mean reversion. Daily Roll The daily roll of commodity exposure seeks to generate roll return, smooth volatility and address some of the return loss associated with futures curves in contango. Beta The beta factor provides broad-based exposure to the diversification benefits and potential profit opportunities of a long/short commodity investment. Cash In declining commodity markets the underlying exposure to commodities may be reduced or short positions established as the cash position is adjusted accordingly to decrease risk and increase absolute and risk-adjusted returns. This innovative method of index construction has historically resulted in lower turnover and higher absolute and risk-adjusted returns than traditional long-only commodity indices.
2010 Annual Review Exhibit 1: Performance Summary Return Risk Standard Deviation Sharpe Ratio Correlation 1-Yr 3-Yr 5-Yr 10-Yr 1-Yr 3-Yr 5-Yr 10-Yr 1-Yr 3-Yr 5-Yr 10-Yr with BCLSI* Bache Commodity Long/Short Index 1.0% 9.1% 9.0% 9.3% 9.4% 12.3% 10.6% 10.9% 0.09 0.70 0.63 0.64 1.00 S&P Commodity Trends Indicator -6.3% -0.2% 4.1% -- 14.2% 21.7% 17.9% -- -0.46-0.04 0.11 --.68 DJ UBS Commodity Index 16.8% -3.7% 1.2% 5.8% 16.8% 24.8% 21.0% 17.7% 0.99-0.17-0.05 0.20.48 S&P GS Commodity Index 9.0% -12.8% -5.7% 1.8% 20.4% 31.9% 27.7% 25.1% 0.43-0.42-0.28-0.02.47 S&P 500 Index 15.1% -2.9% 2.3% 1.4% 17.9% 22.2% 17.8% 16.4% 0.84-0.15 0.00-0.05.03 Barclays US Aggregate Index 6.5% 5.9% 5.8% 5.8% 3.7% 4.2% 3.6% 3.8% 1.74 1.25 0.94 0.93 -.21 * Correlation over 5-year period. Performance Summary The Bache Commodity Long/Short Index (BCLSI) rose 1.0% in 2010. As shown in Exhibit 2 the index started 2010 on a weak note. Long positions that were carried over from the 2009 rally lost money, as US economic data weakened and concerns rose that a double-dip recession could develop. This resulted in lower commodity prices, particularly in the metal and agriculture sectors. The second quarter saw most markets stabilize, although grain prices showed surprising weakness. The BCLSI moved to a net short position in agriculture and energy sectors in June 2010. The second half of 2010 saw steady gains across the metal and agriculture sectors. Growth prospects in China and the US supported prices for industrial metals, and production shortfalls in key agricultural commodities caused price spikes. Initially, the index was not positioned to take advantage of this rally, as most markets were either short or held small long positions. This choppy trading resulted in an 11% drawdown from the start of 2010. The index moved to a net-long position in agriculture in July, as news that a drought in Russia and Ukraine had damaged the wheat crop, and the index remained net long in agriculture for the remainder of the year. Energy markets remained choppy until the final few months of the year, as large crude oil and natural gas stockpiles prevented these markets from participating fully in the global commodity rally. The BCLSI oscillated between long and short positions in energy until September, and was long throughout the fourth quarter. The year-end rally erased the first half s deficit, enabling the index to post its 9th straight annual gain. Comparison with Commodity Benchmarks The Bache Commodity Long/Short Index outperformed the S&P CTI over the 1, 3 and 5 year periods (see Exhibit 1). There are two major differences between the S&P CTI and BCLSI methodologies. The S&P CTI only changes positions once each month, while the BCLSI changes each day. This enables the BCLSI to respond more quickly to changing market conditions. Also, the S&P CTI does not have a cash allocation. It is always fully invested (long or Exhibit 2: Cumulative Return 1 Year 3 Year Bache Commodity Long/Short Index (BCLSI) S&P Commodity Trends Indicator (S&P CTI) S&P 500 Index (S&P 500) Barclays US Aggregate Index (Barc US Agg) 1
short). These differences explain why the BCLSI outperformed the S&P CTI by 7.3% in 2010. Most of the performance difference between the two indices took place in February and July. The BCLSI was flat in February and down 0.8% in July, while S&P CTI had losses of 2.5% and 9.1% in these months respectively. In each of those months, the BCLSI responded to commodity market rallies by reducing short positions and shifting to long positions. However, in both February and July the S&P CTI held large short positions for the entire month, which resulted in sizeable losses for this index. When compared to long-only commodity indices such as the BCI or the DJ UBS, the Bache Long/Short Index showed significant underperformance. Ironically, this underperformance can be largely attributed to the same two major reversals that resulted in the BCLSI outperforming the S&P CTI. Long-only indices were able to fully participate in the February and July rallies, while the BCLSI held neutral positions in both of these months as the model experienced a lag in its position moves as it shifted from long to short positions and vice versa. The volatility of the Long/Short Index was 9.4% in 2010, which is lower than both the S&P CTI and traditional long-only commodity indices. The risk-adjusted returns (Sharpe ratio) of the BCLSI was 0.09 in 2010. This compares to 0.70 over the past three years and 0.63 over the past five years, stronger than the previously mentioned long/short and longonly commodity indices. Exhibit 3: BCLSI Market Factor Decomposition*, 2010 By Commodity Gold Cotton Soybeans Silver Coffee Sugar Copper Live Cattle Nickel Corn Lean Hogs Aluminum Gasoline Wheat Heating Oil Brent Crude Natural Gas Gasoil WTI Crude Oil -3.14% -.02% -.14% -.14% -.19% -.26% -.42% -.78% -1.12% 1.46% 1.34% 1.13%.91%.73%.58%.44%.25%.22%.10% -4% -2% 0% 2% * BCLSI return attributable to each commodity. By Sector Energy Metals Agriculture -5.84% 2.89% -8% -4% 0% 4% * BCLSI return attributable to each sector. 3.93% Sector Analysis Energy WTI crude oil was range-bound between $70 and $85 during most of 2010, roughly in line with the perceived OPEC comfort level of $80. The choppy, trendless trading environment was not conducive to momentumbased trading profits, and the BCLSI energy sector did not perform well. Energy commodities contributed a loss of 5.84% to the BCLSI total return mostly due to WTI crude oil, which contributed -3.14%. None of the energy markets made a positive contribution to the index during the year, though a year-end rally did manage to recover much of the loss. Brent crude oil performed much better than WTI. The index holds about twice as much WTI crude as Brent, but the index losses attributable to Brent crude in 2010 amounted to just 42 bps, about one seventh of the loss from WTI. Metals Gold was the top performing BCLSI commodity in 2010, adding 146 basis points. The spot price of gold set a new all-time high late in the year, and the positive momentum meant that the index was long throughout the year. Silver ended the year with an 80% gain, reflecting tight supplies and rapid adoption of the silver ETF. This led to an 91 bps contribution to the index despite its relatively small 2.5% allocation. Industrial metals were more subdued during the first half of the year. Copper and aluminum prices fell during the spring on fears of a double-dip recession, but then Bernanke s speech in Jackson Hole pushed metals prices into a sustained, four-month rally further buoyed with the announcement of the QE2 stimulus in November. The late surge erased first-half losses in both copper and nickel, but the rally was not enough to push aluminum into positive territory. Overall, the metals sector contributed 2.89% to the BCLSI total return, of which 2.35% came from gold and silver. Agriculture The agriculture sector was the main contributor to performance in 2010, an impressive contribution given its relatively small (29%) allocation in the index. Weakness in export demand during the first half of the year led to lower prices for grains. The BCLSI was short corn, wheat and soybeans at the end of the second quarter. Export demand rebounded in the second half of the year, led by the Chinese. They imported more soy in the final five months of 2010 than in the twelve prior months combined. This, combined with adverse weather in large producing nations such as Russia, 2
Exhibit 4: BCLSI Style Factor Decomposition, 2010-3.50% 0.16% 0.11% 0.97% 4.19% - 8 % - 4 % 0 % 4 % 8 % * See notes for style factor definitions. Beta Factor Daily Roll Factor Dynamic Asset Allocation Factor Collateral BCI L/S Total Return Ukraine, Australia and Argentina, created tight US and global balance sheets and led to a strong bull market. Long positions in corn and soybeans contributed significant returns in the second half of the year. Soybeans added 113 bps to index performance. Cotton added 134 bps a 54% gain on the 2.5% index weight and coffee added 0.73%. Shortages of cotton in China led to several sustained trends. Agricultural commodities contributed 3.93% to BCLSI total return in 2010, with the largest contribution coming from the softs subsector. Contribution of BCLSI Return Factors Commodity beta (see Exhibit 4) was the major driver of returns in 2010, adding 419 bps as the BCLSI is long-biased. The Commodity Beta factor measures the contribution of this long bias to overall index performance. Collateral added 11 bps during the year, and the Daily Roll factor added 16 bps. The asset allocation factor was negative, reducing performance by 350 bps. It is not unusual for the asset allocation factor to be negative when commodity markets exhibit major reversals. There were two sharp reversals during the year that resulted in negative asset allocation returns. The first took place at the start of the year, as concerns about deflation resulted in a sharp sell-off in key commodity markets. The BCLSI was not well positioned for this decline, having started the year almost fully long. Then, in the third quarter, a sharp reversal in grain and metals markets took place when the BCLSI was net short. Most of the negative performance for the asset allocation factor can be attributed to the energy sector as all components exhibited choppy rangebound trading and negative momentum returns. For example, the total return to a long position in WTI crude oil in 2010 (including the negative roll returns) was 2%. However, the BCLSI crude oil return was 3.14% in 2010, as constant market oscillations weighed on the efficacy of the asset allocation factor. Changes to the Long/Short Index Methodology At the January 2011 meeting, the Advisory Committee for the Bache Commodity Long Short Index approved several changes to the Long/Short methodology. Effective February 1, 2011 short positions in all commodities will be increased to 50% of the maximum weight. Previously, the 50% maximum short was applied only to metals and agriculture, while energy markets were limited to 25% short. This change reduces the long bias in the BCLSI seeking to capitalize more fully on potential profits in downward energy markets. On average, the index will now be about 25% long versus 31% long in prior years. The other noteworthy change is an increase in the speed with which changes in the momentum models are incorporated into the index. Previously, changes in asset allocation were quite slow with allocations to individual commodities moving 2-5% per day. This speed will be increased by up to four times (depending on market conditions) which will permit changes in asset allocation signals to be incorporated into index positions much more quickly than before. These changes will make the index a bit more active, with larger short positions permitted and more active movement back and forth between long and short as it seeks to react more quickly to market trends. Back tests of these changes show a historical correlation of 0.96 with the current methodology with slightly better returns. 3
Commodity Outlook for 2011 The macro view for commodity markets is positive in 2011, and the BCLSI enters 2011 with large long positions in every commodity. Looking at specific markets, there is reason to believe that several agricultural markets may have overshot fundamental values in 2010 and prices are likely to revert to levels closer to the cost of production. Producer profit margins in soft commodities cotton, sugar and coffee are unlikely to persist for long. The ability of the BCLSI to hold short positions means it may be able to profit from a return to the secular trend in these markets. Similarly, margins in precious metals mining are at or near all-time highs, and production is certain to increase rapidly in coming years. Wheat prices seem likely to remain at elevated levels given the large supply deficit from 2010. There is also the possibility that the drought in Ukraine may have been so severe that the 2011 crop is endangered as well. This will not be resolved until the spring of 2011 at the earliest. An increase in the amount of ethanol to be blended into US gasoline from 10% to 15% should be supportive for corn prices. Energy markets in the US begin 2011 with near-record supplies of crude oil and natural gas, which has dampened price gains in the US compared to other markets and also led to significant negative roll returns. The BCLSI can profit from contango. When the index is short a contango market, the resulting roll returns are positive. This could become a significant source of return if the steep contango in WTI crude oil and natural gas persists. The Long/Short Index also has significant exposure to the presence (or absence) of short-term momentum in commodity markets. Historically, this factor has added several hundred basis points per year to index performance. In 2010 momentum returns were negative, with the losses concentrated in energy. Momentum returns were positive in both the metal and agriculture sectors. Significant gains in 2011 for the Bache Commodity Long/Short Index will be difficult without a return to positive momentum returns in the energy sector. 4
A1: BCLSI Component Weights 2010 2011 (%) Sector Sub-Sector Commodity Exchange 2011 Max Long 2011 Max Short 2010 Max Long 2010 Max Short Change in Max Weights Energy 47.3-23.7 49.0-12.3-1.7 Crude Oil WTI Crude Oil NYMEX 16.4-8.2 17.0-4.3-0.6 Brent Crude ICE 8.6-4.3 8.0-2.0 0.6 Distillates Gasoil ICE 10.7-5.4 11.0-2.8-0.3 Gasoline NYMEX 2.5-1.3 2.5-0.6 - Heating Oil NYMEX 2.5-1.3 2.5-0.6 - Natural Gas Natural Gas NYMEX 6.6-3.3 8.0-2.0-1.4 Metals 25.7-12.9 21.5-10.8 4.2 Industrial Copper LME 5.3-2.7 4.0-2.0 1.3 Aluminum LME 2.8-1.4 2.5-1.3 0.3 Nickel LME 2.5-1.3 2.5-1.3 - Precious Gold COMEX 12.6-6.3 10.0-5.0 2.6 Silver COMEX 2.5-1.3 2.5-1.3 - Agriculture 27.0-13.5 29.5-14.8-2.5 Grains Corn CBOT 5.1-2.6 5.5-2.8-0.4 Soybeans CBOT 5.0-2.5 6.0-3.0-1.0 Wheat CBOT 3.4-1.7 4.0-2.0-0.6 Softs Coffee NYBOT 2.5-1.3 2.5-1.3 - Cotton NYBOT 2.5-1.3 2.5-1.3 - Sugar NYBOT 2.8-1.4 3.0-1.5-0.2 Livestock Lean Hogs CME 2.5-1.3 2.5-1.3 - Live Cattle CME 3.2-1.6 3.5-1.8-0.3 Total Commodity Exposure 100-50 100-37.8 0 Cash 0 50 0 62.3 0 Notes: Actual allocations to individual commodities can be in a range from 100% to -50%, including 0%. Cash allocation can be in a range from 100% to 0%. Slight differences due to rounding. A2: BCLSI Total Returns (USD) (%), January 1991 to December 2010 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual StDev 1991-0.7 1.0-0.1 1.4 0.9-0.8 0.3 1.7 0.6 2.5-2.4 0.9 5.4 5.8 1992 1.1-0.4 0.1 2.6 3.6-0.1 2.1 0.3 1.1-2.4-0.3 0.4 8.2 5.0 1993-0.9 1.3 1.7 1.6-0.6 0.8 1.0-0.9-2.1-0.9 1.0 2.2 4.4 3.3 1994 1.0-1.2-0.2 2.3 6.0 3.8 3.4-2.7 0.2 0.3 1.3-0.3 14.4 6.4 1995 1.8 0.6 0.9 2.4-0.9 0.8-0.2 1.3 0.2-0.2 1.5 7.3 16.5 5.3 1996-2.1 2.0 6.5 5.4-1.1 2.0-2.0 4.1 4.2 0.7 4.3 3.0 30.0 11.1 1997 0.3 1.5 0.6 1.4 1.0-4.2 0.4 0.6 1.1 1.4-2.5 1.7 3.3 6.6 1998 0.4 1.4-0.7-0.8 0.0 0.9 0.0 2.5-0.4-4.4 0.3 0.2-0.9 4.8 1999-0.7 0.8 3.5 3.8-3.4 3.1 2.5 4.3 3.8-3.8 1.8 2.1 19.0 10.0 2000 3.3 5.7-0.4 0.1 5.9 5.4-4.2 6.1-0.5 0.1 4.0 0.2 28.2 12.6 2001-3.2 0.9 1.3 1.0 0.2-0.1 0.5 0.6-3.6 0.2-1.2 0.0-3.5 6.7 2002-1.0 0.8 8.9 1.0-2.9 0.7-0.2 1.9 2.7-2.7-1.0 2.0 10.0 10.4 2003 7.3 6.6-7.7-1.5 0.1-0.5 1.2 2.1-2.7 0.9-0.4 2.9 7.7 12.5 2004 2.0 6.5 2.2 1.6 3.3-1.6 4.7-2.0 6.5 2.6-2.0-1.5 24.2 13.4 2005 0.2 1.1 5.3-4.3-1.4-1.6 3.3 10.2 2.5-4.1 1.7-1.0 11.6 11.6 2006 2.6-3.2 1.4 4.2 0.3-0.9-0.2-2.1 1.0 0.8 0.4-0.7 3.7 7.9 2007-1.1 1.9 0.9 0.6-1.4 0.9 2.9-2.0 3.6 5.8-1.7 3.4 14.3 8.9 2008 0.1 6.1-1.9 4.9 6.4 6.1-8.6-2.2 1.2 6.2 3.1 2.3 25.0 14.8 2009 0.6-0.4-0.9-0.2 6.8-0.6-1.8 0.3-0.9-0.4 1.4-0.9 2.9 11.3 2010-4.1 0.0 1.8 1.4-6.6-1.3-0.8-1.2 3.2 2.6 0.1 6.4 1.0 9.4 Full Period 10.9 9.5 Notes: Returns Total returns include 91-day Treasury bill return, in percentage. Annual Compounded annual return. StDev Annualized standard deviation of of daily returns for each year; annualized standard deviation of monthly returns for full period. Full Period Compounded annualized return and annualized standard deviation of all monthly returns. 5
Disclosure Prudential Bache Asset Management, Inc. (PBAM) is a business unit within the Bache Commodities Group. PBAM is registered with the U.S. Securities & Exchange Commission as an investment adviser and the U.S. Commodity Futures Trading Commission as a commodity trading advisor. PBAM is also a member of the National Futures Association. PBAM s parent company, PFDS Holdings, LLC, is the owner and developer of the intellectual property that drives the Bache Commodity Index series. Bache Commodities Limited (BCL), PBAM s UK-based affiliate, is regulated by the Financial Services Authority. Bache Commodity Long/Short Index returns prior to July 2009 are based on simulated or hypothetical performance that has certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity and trading expenses. Simulated or hypothetical trading programs in general are also subject to the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to the ones shown above as past performance is not indicative of future results. The comments, opinions and estimates contained in this document are based on, or derived from publicly available information from sources that Bache Commodities Group believes to be reliable. We do not guarantee their accuracy. This information is provided for informational purposes only and sets forth our views as of this date. The source for all charts and graphs is Bache Commodities Group, Bloomberg, LP and DJIndexes.com unless otherwise stated. Bache Commodity Index and BCI are registered service marks of The Prudential Insurance Company of America, Newark, NJ and its affiliates. Bache Commodity Green Index and BCGI are service marks of The Prudential Insurance Company of America, Newark, NJ and its affiliates. The methodology of, and intellectual property rights in, the Bache Commodity Index are proprietary to, and owned by, PFDS Holdings, LLC., and may be covered by one or more pending patent applications. Bache and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide. Prudential Financial, Inc. of the United States is not affiliated with Prudential plc. which is headquartered in the United Kingdom. 2011 Prudential Financial, Inc. and its related entities. Notes: i. BCLSI returns quoted in this report are for the Total Return version of the index, which includes the return of the 3-month Treasury Bill yield in addition to the return attributable to changes in the underlying futures contracts. ii. Standard deviation is calculated as annualized standard deviation of daily total returns except for time periods more than one year. iii. Beta Factor is 70% of the return to the fully invested index (Excess Return). iv. Asset Allocation Factor is the return provided by the dynamic risk reduction methodology. v. Daily Roll Factor is the incremental return attributable to the use of the daily roll methodology versus rolling at the end of the roll period. vi. Collateral is based on the 3-month Treasury Bill yield. 6