Capitalizing on the Commodities Market despite Extreme Volatility - Presentation: Michel Toupin, Laval University Pension Fund - Canadian Institutional Investment Summit

G U E S T S P E A K E R :

M I C H E L T O U P I N , M A N A G I N G D I R E C T O R

F O N D S C O M M U N D E P L A C E M E N T D E S R É G I M E S D E

R E T R A I T E D E L ’ U N I V E R S I T É L AV A L

Canadian Institutional Investment Summit

« CAPITALIZING ON THE COMMODITIES MARKET

DESPITE EXTREME VOLATILITY »

October 17-19, 2011 - Hilton Lac-Leamy,

Gatineau-Ottawa, Quebec

ORDER OF PRESENTATION

Canadian Institutional Investment Summit Oct. 2011

2

GENERAL OBJECTIVE

PENSION FUNDS OBJECTIVES AND PROCESS

COMMODITIES PORTFOLIO

A transfer of risks

Some indices

An inadequate substitute, regional consideration

A risk-reward perspective

CORRELATIONS ANALYSIS

IMPLEMENTATION

A GLOBAL PERSPECTIVE – DEMOGRAPHY AND URBANIZATION

OTHER CONSIDERATIONS AND CONCLUSIONS

PRESENTATION - GENERAL OBJECTIVE


3

« To describe a commodities portfolio and to introduce its benefits for a pension fund .


4

PENSION FUNDS OBJECTIVES AND PROCESS

COMMODITIES AND PROTECTION


5

Two combined strategies

« to provide a protection against inflation and its

effects upon the liabilities as well the assets, no

matter the source of inflation» (considering the

commodities as a potential source)

« to reduce the global risk through a more

efficient diversification »

COMMODITIES – « THE ORIGIN »

A case : Laval University Pension Funds


6

COMMODITIES FOR INSTITUTIONAL INVESTORS -

A SPHERE OF INFLUENCES IN 2011


7

THE COMMODITIES MARKET

A TRANSFER OF RISKS BETWEEN PLAYERS


8

Bond Holder

Shareholder

Speculator-Arbitragor-

Hedge Funds

Diversified Investors

Commodity

ProducerTransformer-Final UserFinal sales

hedging

hedging investing


9

TWO COMMODITY INDICES

AND THEIR CONTENT

REGIONAL

CONSIDERATIONS AND

OPTIMISATION


10

AN INADEQUATE SUBSTITUTE (1)

Canadiani Institutional Investment Summit Oct. 2011

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• Question : Can we replace a Commodity Index (such as The

Goldman Sachs C. Index) with Canadian Stocks?

• Answer : No

1. Correlation between 4 sectors or sub-sectors of the TSE 300 and

the GSCI: Mines and Metals, Gold and Precious Metals, Oil and Gas and Pipelines versus Goldman

Sachs Index (all sectors)

• Result :

to have the best correlation TSE 300/ GSCI = 0,41 the model

keeps only Mines and Metals (TSE300), rejects others

2. Correlation between the TSE 300 (all sectors) and the GSCI :

maximum correlation = 0,42, the model keeps only Oil and Gas

and Gold Precious Metals (TSE300), rejects others

AN INADEQUATE SUBSTITUTE (2)


12

• Correlation between the TSE 300 (all sectors) and the GSCI -

Energy :

maximum correlation = 0,49 between the TSE 300 and the GSCI, the model keeps 1 sector of the STX300, Oil and Gas;

Finding:

We tried to replicate, from a canadianperspective, the market behaviour as defined bya commodities index but, we failed.

What’s a possible explanation ?

CHOOSING BETWEEEN COMMODITIES AND STOCKS

A CASE : IShare Commodity Index and Chicago Mercantile

Exchange Group (the stock)


13

-25%

-35%

CME Group

I Share Commodity Index

Difference = Business or “Non-

Systematic” Risk ?

CORRELATION ANALYSIS(QUANTITAT IVE PROCESS)

HOW TO DETERMINE THE

PROPORTION, APPROPRIATE VERSUS

ACCEPTABLE


14

RISK-REWARD ANALYSIS

SIMULATION WITH SIX MARKET INDICES

Indice Rendementespéré

Rendement au90

ième rang

centile

Rendement au10

ième rang

centile

GoldmanCommodities

8,4% -14,9% 26,4%

MSCI EAFE 9,4 -12,8 28,6

S&P 500 17,5 -0,2 34,9

TSE 300 3,6 2,4 4,8

SMc Univers 7,7 -0,8 14,8

Russell 2000 14,2 -8,0 35,7


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January 1992 to December 2000, Cdn $.

Expected

returnIndex Ranking 90 th Ranking 10 th

worstClose to

median

Close to

median

ADDING COMMODITIES

A RISK-REWARD OPTIMIZATION

Matièrespremières =

0%


2%


6%


8%

Rendementespéré 4,6% 4,6% 4,6% 4,6%95

ième rang centile -3,6 -3,4 -3,0 -2,8

Probabilitéd’échec ( sur 3 ans

r.min=0%)

19,4 17,8 16,3 15,7

Rendementbaissier espéré(r.moy sous 0)

-2,7 -2,6 -2,4 -2,3

Titres departicipation(1/3, 1/3, 1/3)

55,0 53,0 49,0 47,0

Titres d’emprunt(1% mm et 44% obl.) 45,0


16

Les rendement sont exprimés en termes réels

Commodities =

StocksBonds

Expected return

Probability of

missing the MAR

0% 2% 6% 8%

CANADIAN AND FOREIGN STOCK MARKETS

COMPARED VOLATILITIES


17

R e t u r nJ a n u a r y 1 9 8 8 - A u g u s t 2 0 1 1

R a n g e o f R e t u r n s f o r 3 In v e s t m e n t C a t e g o r ie s

S & P G S C I T R C A D M S C I E M A s i a U S D S & P / T S X E n e r g y T R

- 3 0 . 0 %

3 0 . 0 %

- 2 8 . 0 %

- 2 6 . 0 %

- 2 4 . 0 %

- 2 2 . 0 %

- 2 0 . 0 %

- 1 8 . 0 %

- 1 6 . 0 %

- 1 4 . 0 %

- 1 2 . 0 %

- 1 0 . 0 %

- 8 . 0 %

- 6 . 0 %

- 4 . 0 %

- 2 . 0 %

0 . 0 %

2 . 0 %

4 . 0 %

6 . 0 %

8 . 0 %

1 0 . 0 %

1 2 . 0 %

1 4 . 0 %

1 6 . 0 %

1 8 . 0 %

2 0 . 0 %

2 2 . 0 %

2 4 . 0 %

2 6 . 0 %

2 8 . 0 %

2 3 . 0 %

- 1 7 . 9 %

2 2 . 0 %

- 2 4 . 2 %

2 3 . 3 %

- 2 1 . 1 %

H i g h e s t :

A v e r a g e :

L o w e s t :

L e g e n d

COMMODITIES

ALTERNATIVE PORTFOLIOS

COMMODITIES VARYING FROM 0% TO 50%


18

R i s k ( S T D )

R e t u r n ( A M )D e c e m b e r 1 9 9 9 - D e c e m b e r 2 0 1 0

R E L A T IV E S P E R F O R M A N C E S A N D R IS K S

1 . 0 % 6 . 0 %1 . 3 % 1 . 6 % 1 . 9 % 2 . 2 % 2 . 5 % 2 . 8 % 3 . 1 % 3 . 4 % 3 . 7 % 4 . 0 % 4 . 3 % 4 . 6 % 4 . 9 % 5 . 2 % 5 . 5 %

- 0 . 1 %

0 . 9 %

0 . 0 %

0 . 1 %

0 . 2 %

0 . 3 %

0 . 4 %

0 . 5 %

0 . 6 %

0 . 7 %

0 . 8 %

P o r t f o l i o ( 1 )

P o r t f o l i o ( 2 )

P o r t f o l i o ( 3 )

P o r t f o l i o ( 4 )

P o r t f o l i o ( 5 )

• (% of total port.) 1 2 3 4 5

• Commodities 16,7 0 20 25 50

• Large Cap. US 20 20 25

• (Russell 1000)

• MSCI EAFE 20 0

• Large Cap. Can. 0 25

• (S&P/TSX 60)

• DEX Real Retrn. 20 25

• DEX All Gov. 20 0 50

Alternative portfolios

1 50% COMMODITIES

NO COMMODITIES

COMMODITIES –INFLATION AND INTEREST RATES

WHO COMES FIRST ?


19

Consumption Wars, Catastrophes, OPEC

Demand

Oil Other

Products

GSCI Commodity Index

Canadian Interest rates

Real estate

Offer

Inflation US

US Interest rates

Inflation CDN

Real Return Bonds

MONETARY

POLICIES

COMMODITIES AND INFLATION

CORRELATION FROM 1996 to 2011


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In te rva l: 24

C o rre la tio n V a lu e s

Correlation Rolling Period 24 M onths

0.0%

80.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

55.0%

60.0%

65.0%

70.0%

75.0% 76.3%

D e c1996

Ju n2011

De c2000

De c2005

S & P G S C I T R vs. IA S B B I U S In fla tio n

FINANCIAL CRISIS

MATURE PENSION FUNDS

PARTICULAR NEEDS


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Constraints

An urgent need to finance or match the annuities adjusted for inflation ;

Strategy (depending on each pension fund)

Matching inflows and outflows in terms of :

Dollars matching,

Sensibilty to market movments,

Timing of entry-exit, perfect synchronisation whenimplementing


22

COMMODITIES AND

IMPLEMENTATION ISSUES

PORTFOLIO IMPLEMENTATION

THE BEST IS HAVING GOOD TIMING…. (easy to say !)


23

COMMODITIES AND THE CURRENCY EFFECTTO AVOID A « ZERO-SUM GAME » BECAUSE OF AN APPRECIATION

OF THE CDN $


24

COMMODITIES

CANADIAN DOLLAR

profits

losses

AFTER IMPLEMENTATION OF COMMODITIES

VARIOUS CORRELATIONS


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I n t e r v a l : 6 0

C o r r e l a t i o n V a l u e s

C o r r e la t io n R o llin g P e r io d 6 0 M o n t h s ( C D N $ )

- 2 0 . 0 %

6 0 . 0 %

- 1 8 . 0 %

- 1 6 . 0 %

- 1 4 . 0 %

- 1 2 . 0 %

- 1 0 . 0 %

- 8 . 0 %

- 6 . 0 %

- 4 . 0 %

- 2 . 0 %

0 . 0 %

2 . 0 %

4 . 0 %

6 . 0 %

8 . 0 %

1 0 . 0 %

1 2 . 0 %

1 4 . 0 %

1 6 . 0 %

1 8 . 0 %

2 0 . 0 %

2 2 . 0 %

2 4 . 0 %

2 6 . 0 %

2 8 . 0 %

3 0 . 0 %

3 2 . 0 %

3 4 . 0 %

3 6 . 0 %

3 8 . 0 %

4 0 . 0 %

4 2 . 0 %

4 4 . 0 %

4 6 . 0 %

4 8 . 0 %

5 0 . 0 %

5 2 . 0 %

5 4 . 0 %

5 6 . 0 %

5 8 . 0 %

4 4 . 2 %

3 8 . 2 %

2 9 . 4 %

1 7 . 4 %

1 1 . 0 %

D e c2 0 0 4

A u g2 0 1 1

M a r2 0 0 5

J u n2 0 0 5

S e p2 0 0 5

D e c2 0 0 5

M a r2 0 0 6

J u n2 0 0 6

S e p2 0 0 6

D e c2 0 0 6

M a r2 0 0 7

J u n2 0 0 7

S e p2 0 0 7

D e c2 0 0 7

M a r2 0 0 8

J u n2 0 0 8

S e p2 0 0 8

D e c2 0 0 8

M a r2 0 0 9

J u n2 0 0 9

S e p2 0 0 9

D e c2 0 0 9

M a r2 0 1 0

J u n2 0 1 0

S e p2 0 1 0

D e c2 0 1 0

M a r2 0 1 1

D J U B S C o m m o d i t y T R U S D v s . R u s s e l l 1 0 0 0 T R U S D D J U B S C o m m o d i t y T R U S D v s . M S C I E A F E U S DD J U B S C o m m o d i t y T R U S D v s . S & P / T S X 6 0 T R D J U B S C o m m o d i t y T R U S D v s . D E X R e a l R e t u r n B o n d T RD J U B S C o m m o d i t y T R U S D v s . D E X L T A l l G o v e r n m e n t s T R

FINANCIAL CRISIS

REAL RETURN BONDS

S&P/TSX60 TR

AFTER THE IMPLEMENTATION

A PERPETUAL MONITORING


26

YEAR 1 : Two managers, same index : GSCI Core, index approach

YEAR 4: One manager, one index : GSCI Light Energy (agriculture under represented)

YEAR 7: New manager (3rd) : Dow Jones, more “balanced”

Fees less than 30 pb, no incentive,

Continual challenge : strict discipline

DEMOGRAPHY AND URBANIZATION


27

A GROWING DEMAND FOR

COMMODITIES

WORLD GROWTH AND DEMOGRAPHY

POPULATION OF “LDC’S” INCREASES BY 50%


28

Source : United Nations

100%

URBANIZATION AND POTENTIAL DEMAND

FOR COMMODITIES


29

Source : United Nations


30

OTHER CONSIDERATIONS AND CONCLUSIONS

A FIDUCIARY PERSPECTIVE


31

Pros’

A proven diversificationtool

Technical factors

No default risk, clearinghouse

Extreme liquidity

Efficient if you manageadequately the collateral

Cons’ Source of nervosity or source of

exuberance

Test your capacity to maintain

discipline while assuming your

choice (decided allocation and

indexing, if any)

The investment is original and

rapidly appear a conflict

between prudence and the

optimal allocation to maintain

COMMODITIES AND CURRENT YIELD

A CHALLENGE FOR MATURE PENSION FUNDS


32

• Bet on the performance instead of the current yield ;– Commodities : generate a pretty weak yield from the money

market, the price appreciation makes the difference :

– Real estate : generate positive cash-flows on a monthlybasis, the cash-flows may be indexed depending on the sector ;

– Real return bonds : generate a series of coupons fully indexedwith a possible capital appreciation.

COMMODITIES

DIVERSIFICATION TOOL


33

The « tolerance point » is intuitive and seems to be around 10% of the total portfolio although…

The « optimal point » may reach » up to 25% of the total portfolio (rarely seen…);

A target around 8% is a risk-reducer which keeps constant the performance of the total portfolio;

The real value behind commodities is its weak correlation withtraditional invesments. Caution : the « ups’ and downs’ are frequent and may be important.

COMMODITIES – LITTLE-KNOWN ASPECTS

A COMBINATION OF CHALLENGES


34

RATIONAL AND MEMORY TO JUSTIFY THE

PRODUCT

(DIVERSIFICATION VERSUS

SPECULATION)

DISCIPLINE TO MAINTAIN THE

PRODUCT

(IN ADVERSE CONDITIONS)

LUCK TO INTRODUCE

THE PRODUCT

(YOU NEVER KNOW WHEN)

CONCLUSIONS


35

Since we measure our performance attribution, commodities added up to 40-50 pb. To the total performance

You should consider to hedge the US position on commodities, our hedge ratio is 50% of the US exposure (based on a frequent evaluation of the market value)

Ask your consultant to :

Identify the “good” index, test more than one ;

To do not try to time the market when implementing and after and,

• Remain indexed until you feel comfortable with the asset class