Perspective on a Commodity Benchmark


Active vs Passive Management Styles

Which investment approach is best — active management or passivemanagement? Advocates for each insist their style is superior, capable of generating the best performance over time. Each has its advantages and disadvantages, but in the end only an investor can determine which makes the most sense for their specific portfolio.

In this issue of Investor Notes we will take a closer look at both styles as we review a commodity benchmark and a managed futures product. Specifically, we will use the Dow Jones AIG Commodity Index as our passive management proxy and the Chickasaw Composite as our active management proxy.

First and foremost . . .

The passive versus active management debate generally pertains to the equity markets and NOT to the commodity arena. Why? The answer lies in the characteristics of the asset groups. Due to benefits of capital formation, stocks have an historic bullish bias that typically helps passive investments, especially during secular bull markets. Commodities, on the other hand, exhibit a cyclical nature (i.e. an ebb and flow characteristic) that is generally more receptive to an active management style.

Referring to Chart 1, we see that commodities can run hot and cold. Over the past ten years, commodities have gone through a series of phases (three up and two down). Through it all, the Dow Jones AIG Commodity Index generated a respectable 6.58% compounded annual rate-of-return. The fact is, however, that when the next bearish phase begins, investors tied to this passive investment style will have to endure an extended period of poor performance. Simply put . . . the Dow Jones AIG Commodity Index offers diversification, but it does require active management to potentially produce above average returns.

Chart 1: Historical Performance
Dow Jones AIG Commodity Index (Dec. 1994 - Dec. 2004)

When it's good it's really GOOD.

Recently the Dow Jones AIG Commodity Index has been on a tear, generating a 13.40% Compounded Annual Rate of Return over the past two years (2002 - 2004). See Chart 2 below. These results are all the more impressive given that managed futures products like those offered by Chickasaw Capital and Lexington Asset Management have produced flat to slightly negative results over the same time period.

Chart 2: Short-Term Comparison
Chickasaw Composite vs. Dow Jones AIG Commodity Index (Dec. 2002 - Dec. 2004)

Why the disparity in returns?

• Generally speaking commodities have been choppy, making it difficult for active managers to hold positions. Choppy markets simply force active trend trading managers to trade very inefficiently. Passive investments can ride the wave (volatile or not) to the upside making the easy money while it lasts.
• The surge in commodity prices over the past two years has been limited to a few sectors with the most notable sector being the energies. The Dow Jones AIG Commodity Index is HEAVILY weighted in this sector with 33% of its entire portfolio invested in energies. That’s a big bet in comparison to the diversified portfolios of Chickasaw Capital or Lexington Asset Management. We on the other hand, believe in a well balanced and diversified approach to asset management.
• Managed futures products like those offered by Chickasaw Capital or Lexington Asset Management invest across a wide variety of sectors in addition to commodities. The fact that we include currencies, interest rates, and stock indices in our portfolio dilutes assets allocated to commodities. The benefits associated with diversification requires one to look beyond the short-term.

Longer-term Perspective.

Over the recent short-term, passive investments have out performed some actively managed investments. In our study, a longer-term analysis, shows the true benefits of an actively managed and fully diversified program. Chart 3 compares the Dow Jones AIG Commodity Index with the Chickasaw Composite over ten years. In this instance, the passive investment generated a 6.58% compounded annual rate-of-return, while the actively managed investment produced a very healthy 17.40% compounded annual rate-of-return. Over the short-term anything can happen. For a true perspective on performance a longer-term time horizon is required to fully appreciate an actively managed fund product.

Chart 3: Long-Term Comparison
Chickasaw Composite vs. Dow Jones AIG Commodity Index (Dec. 1994 - Dec. 2004)

An Equity Comparison.

Over the past ten years the Chickasaw Composite has easily outperformed the Dow Jones AIG Commodity Index. Perhaps even more impressive, they also outperformed the S&P 500, NASDAQ and Warren Buffett’s Berkshire Hathaway stock over the same time period. All long-term investment products have their ups and downs. Successful long-term investors recognize this fact and are willing to give their investments room to grow.

Chart 4: Equity Comparison (Dec. 1994 - Dec. 2004)

Outcome Risk vs. Investment Time Horizon.

In our example, we consider a case where an investor, excited by the prospects of a new investment, chases performance and buys at a market top. How much time should an investor be willing to commit to an investment product to turn a profit? And how does outcome risk relate to time horizon? To answer these questions we need to evaluate an investments from an outcome risk perspective. A quick review of various performance time frames will give an investor a basis on which to establish reasonable expectations.

The historical worst performance scenario assumes that an investment is made at the most inopportune time. For example, over the ten-year time window, we evaluate the worst performing one-year time period on a rolling basis. The analysis continues as we evaluate the investment’s worst returns for a two-year period, three-year period and so forth. This gives an indication on the time commitment necessary to reach a break-even point under the worst circumstances during the evaluation period.

Table 1 provides a comprehensive overview of the rolling period analysis. The change in color from red to green represents the time required for an investment to turn a profit based on the worst rolling historical performance.

Table 1: Rolling Period Analysis
(Dec. 1994 - Dec. 2004)

As with anything in life, we want to wait for positive confirmation before we “take the leap.” We need “positive data” before we buy. Unfortunately, long-term investments tend to be cyclical in nature. They have their good periods and they have their challenging periods. Trying to determine when the good periods are going to take place is very difficult, even for the managers on the inside. The best way to insure that you participate in the good periods is to make a commitment to stay in through the challenging markets, which will require “riding out the storms.” The upside is that when the good periods come, you are in a position to participate. At the end of the day, you may have to lose a few battles in order to win the war

Chart 5: Historical Worst Rolling ‘n’ Year Performance Comparison
(Dec. 1994 - Dec. 2004)

Drawdown Perspective:

Drawdown is a measure of risk. It is calculated as the percent change from equity peak to equity valley. Essentially, it’s the pain investors must endure if they are to hold onto their long-term investments. Few would question the performance of the stock market over time, but there are times when it can test the patience of even the most seasoned investor. So during tough times in equities how have other investments performed?

Let’s take a closer look at the top five historical drawdowns in the S&P 500 Index over the past ten years and compare them against the performance of the NASDAQ, Berkshire Hathaway, Dow Jones AIG Commodity Index and Chickasaw Composite over the same time period.

Chart 6 and the corresponding table outline the largest drawdown periods as measured by the S&P 500. The worst performance period began in August 2000, when the S&P 500 Index experienced a -46% drawdown. Over the same time period the Chickasaw Composite generated an +83% return, helping to offset losses in equities. The Dow Jones AIG Commodity Index during the same time period was able to turn a profit, but comparatively, it was not enough to truly influence the bottom line.

Chart 6: Drawdown Comparison
Top five S&P 500 Index drawdowns vs various benchmarks (Dec. 1994 - Dec. 2004)

Table 2: Drawdown Analysis by the Numbers
(Dec. 1994 - Dec. 2004)

Active versus passive investment styles; the debate continues.