Transcript

Olly Ludwig: Early this summer, we launched Vanguard Commodity Strategy Fund. It’s Vanguard’s first foray into the world of futures-based funds targeting the wild world of commodities. In case you were wondering if you heard that right, that Vanguard launched a commodities fund, you did. And if you’re surprised, well, you’re not alone. Today we’re going to explore that surprise and a lot more, including some specifics regarding the new Vanguard fund.

Welcome to Vanguard’s Investment Commentary podcast series. I’m Olly Ludwig, and in this month’s episode, recorded August 15, 2019, our exploration into commodities investing will be guided by Frank Chism, senior product manager at Vanguard’s Portfolio Review Department. Frank’s expertise is in alternative investments, including commodities, so we’re in good hands today.

So let’s get right into it. Frank, it’s a real pleasure to be with you in the podcast booth.

Frank Chism: Thanks, Olly, glad to be here.

Olly Ludwig: So I’m just going to put it right out there, the sense of surprise that I talked about at the top. Why commodities, and why now?

Frank Chism: Well, Olly, you know, it’s true when you think about Vanguard, you don’t necessarily think about alternative investments, commodities, things of that …

Olly Ludwig: I mean the history of Vanguard, it’s, you know, stocks, bonds, cash, end of story, right? This is a new story line, right?

Frank ChismFrank Chism: This is new. This is different, yes, absolutely. It’s something that we have been doing for a while as part of one fund that we run. We had a commodity sleeve in that that we’ve been managing, but we really wanted to make that available to more investors. A lot of what’s changed for us is, we’ve realized and really recognized that we have lots of different investors—and if you think about when we started, we mainly worked with retail; we had a lot of retirement plans; and as we’ve grown, we have a lot of financial advisors, as we know, who use our products; we have institutions who use our products; and so we don’t have one end-client, we have a huge range of sophisticated investors—and that they have more sophisticated needs.

Olly Ludwig: So let’s get into the details. Commodities investing has been around a long time.

Frank Chism: Like forever.

Olly Ludwig: Yeah, yeah. The first futures contracts were in ancient Mesopotamia, if I’m not mistaken. And it sounds like I’m making stuff up, but I’m not. This has been around a long time.

Frank Chism: Yes.

Olly Ludwig: Gold, soft commodities such as grains.

Frank Chism: Corn, grains.

Olly Ludwig: Industrial commodities, like copper, that are crucial to building things. It’s been around since forever, right?

Frank Chism: It’s been around. So it’s a lot of things that we see. People hear of new things in the investment world. Most of it’s not new. Very little is new. Commodities aren’t new. I think what’s new for us about it is developing a way to think about how can you use something like commodities in a portfolio.

Olly Ludwig: Sorry to interrupt you, but we talk about the application. The modern piece, or relatively modern piece, would be some of the research that’s been coming out—certainly in the twenty-first century. I’m thinking about guys like Geert Rouwenhorst.

Frank Chism: Yeah, yeah.

Olly Ludwig: I just butchered his name. He’s Dutch, and I hope he doesn’t hear this and say, “Oh, my gosh.” And his colleague, Gary Gorton. They laid it out: “Hey, this can be done. And you know what, you should do it.”

Frank Chism: Yeah, I think that’s the thing. And we’ve published some research on this as well. What are you getting from commodities when you think about how to use them in a portfolio? From a return point of view, I can’t guarantee what you’re going to get necessarily, but there’s a lot of research and a lot of thought around [how] commodities will behave very differently than the other things in your portfolio. So if you have equities and fixed income, commodities may provide a diversification benefit because they move very differently. Their returns are really driven by very different events in both the market and the world.

Olly Ludwig: That’s a diversification piece, and then there’s an inflation piece as well that’s extremely important, right?

Frank Chism: Yes. And then the real reason, I think, most investors include commodities in their portfolios is, they tend to provide inflation protection. They react very strongly to inflation. So if you have an unexpected inflation event, your commodities should react with a lot of magnitude in the same direction as inflation.

Olly Ludwig: Right. That being said, this isn’t a product for everybody, right?

Frank Chism: It’s not. It’s an interesting thing for Vanguard. Normally, I think, when you look at the history of our product development and what we’ve launched, we tend to launch things that we would argue are good for just about everybody.

And this is not the kind of investment where we’re going to pound the table and say, “Everyone should have X percentage of commodity holdings in their portfolio.” This is a product that’s designed for sophisticated investors who want further diversification beyond stocks, bonds, and cash. Stocks and bonds tend to be uncorrelated. However, if you have a meaningful amount of money, or you have a near-term spending need, it can help to have an additional diversification benefit. And then, two, this is really geared for folks who have a real concern about inflation.

So it’s really not for everyone. It is going to be for folks who meet either of those criteria: “I want a lot more diversification, or I have a real concern about inflation.”

Olly Ludwig: What about this idea that people just dismiss it just because being long commodities is, you know, you’re just betting against the human race of innovating with interesting technology and science and what have you?

Frank Chism: Yeah. I’ve met with a lot of clients so far, and the interesting thing is, most investors who have commodities in their portfolio today, they’re going to keep it there. They believe in it. It’s going to help provide inflation protection. It’s harder for someone who doesn’t already own commodities to think about buying commodities, for several reasons.

First is, they haven’t performed very well, right? Let’s be honest. Over the last ten years, commodities—it depends a little bit on how you measure it—but for the most part, it’s been a negative return.

And then the second thing is, if you look forward, if you think about things like solar and wind and how the world is changing how we use it—that’s energy, of course—but even ways we can grow commodities and corn and how we think about how that’s done, you could be saying: “Yes, if I’m going to buy commodities, I’m going to bet against humans’ figuring out how to do it better.”

That said, we don’t know, Olly, is that going to happen next week? Is that going to happen 5 years from now, 10 years from now, 15? We don’t know when the changes are going to take place. And in the interim, if you need inflation protection, this is still probably one of the best ways to do it.

Olly Ludwig: I was thinking about a quote that’s attributed to John Maynard Keynes, but like so many quotes, it’s probably not from him. But it’s something along the lines of: “Markets can remain irrational a lot longer than you or I can remain solvent.”

That’ll be taking the other side of that argument—that you’re betting against human ingenuity. But, okay, you want to lose your shirt while you bet against …

Frank Chism: Right. So, commodities may provide real benefit today, whether or not the changes that some people may say are coming [happen]. While we’re waiting for those changes, commodities may still benefit.

Olly Ludwig: Yeah, that’s a perfect pivot point. So put on your nerd hat, and let’s talk about the new product.

Frank Chism: Sure.

Olly Ludwig: And just to kind of get your creative juices flowing, I want to talk about, as a first subject, the expense ratio.

Frank Chism: Sure.

Olly Ludwig: Twenty basis points. I’m thinking that’s relatively low in this realm.

Frank Chism: Yeah, absolutely.

Olly Ludwig: Speak to that.

Frank Chism: Sure. There’s a lot of talk lately about fee compression, and investment products just get cheaper and cheaper and cheaper. That has happened in indexing, parts of active management, both on the equity and fixed income sides.

But some of these other realms or sort of niche-ier products like commodities, alternative investments, you know, the costs are still relatively high. So when we think about coming into this market at 20 basis points, that’s meaningfully less expensive than if you look at the industry average, certainly. So we’re definitely going to be way down at the lower end in terms of offering an active strategy in the commodity space at 20 basis points.

Olly Ludwig: Active.

Frank Chism: Yes.

Olly Ludwig: I’m glad you said that, because I haven’t said that yet, I don’t think.

Frank Chism: I don’t think you have.

Olly Ludwig: That’s important. Let’s talk about how is it active?

Frank Chism: Sure. So it’s active in a handful of ways. And the reason—let’s go back, too, and talk about why would you want to do commodities in an active way? The interesting thing about the commodity market is there’s a handful of structural things about the way the commodity market functions that allows professional investors to pick up a little bit of excess return. And I’ll talk about in a second how we do it.

But one of the main reasons to be active in the commodity market, and particularly with the commodity fund, is you’re seeking inflation protection for your portfolio, right? That’s what we talked about earlier. And if I’m trying, in essence, to obtain protection, how do I take some of the edge off of that cost? So you go active to try to add a little incremental return over and above what commodities is providing.

We do it in two ways really. We do it on the commodity side around how we select contracts, either in (a) how we select futures contracts and then, secondly, how do we roll those?

Olly Ludwig: And just to get it out in the open, how many commodities are in this fund?

Frank Chism: Twenty-four. We follow the Bloomberg Commodity Index. So, yes, 24.

Olly Ludwig: So that’s always going to be 24. Always more or less the way the index portions them.

Frank Chism: Well, we’ll match the weights of the index.

Olly Ludwig: Got it. That’s the word I was reaching for there a moment ago. So, yes, keep going on the active components of this strategy.

Frank Chism: So we’re active in two ways. On the commodity side, we’re going to be a little different in how we select contracts, which contracts are we choosing to hold, how we rebalance those contracts.

And then on the collateral side—and the way to think about a fund is, you don’t have to put up $100 to get $100 worth of commodity exposure. You just put up a margin, which is usually, say, 10%, or $10. And then the rest of that money you hold in some kind of collateral. The index holds it in Treasury bills, so you just get short-term interest rates basically. What we’re going to do is put that into short-term Treasury Inflation Protected Securities, or TIPS. So instead of having just a cash return, we’re going to get an inflation-based return that’s going to help when we have inflationary moments.

Olly Ludwig: It harmonizes with the inflation-protection aspect of the entire fund. You have this collateral that’s in an inflation-protection instrument itself, is what you’re saying.

Frank Chism: Yes, exactly.

Olly Ludwig: Yes. That’s a cool idea. And anything else on the active front, rolling strategy, for example? I’ve just carted out a nerdy term. Maybe you can hold our readers’ hands.

Frank Chism: Yeah. Well, there’s two ways to think about commodities. I mean, you can say, like, “I’m going to get a commodities fund. I’m going to have access to the commodities market, and I’m done.” That’s sort of the end of my thinking about it. And then there’s the next level of, you know, which contracts am I going to hold? Where am I going to be on the curve? Am I going to pay attention to the shape of the curve? Like, we could spend all day, quite honestly, talking about the way to do this.

But one way to think about what we’re doing is, the index—the Bloomberg Commodity Index, which is our benchmark, and that’s kind of our starting point—they roll all their contracts over five days. These contracts are short-term in nature. They’re going to do it over five days at the end of the month. We’re going to stretch that out a little bit so we’re not trading on the most congested days, right? So that’s one way we’re going to add value in the fund.

And then the second thing is, the Bloomberg Commodity Index uses the near-month contract. So they’re always looking at next month’s contract, and generally, because that’s the most liquid contract, etc. We’re just going to go out a little bit further on the curve with some of our contracts. The further out on the curve you go, you pick up a little liquidity premium.

So we’re not dramatically active. We’re not overweighting/underweighting any individual commodity. We’re just trying to be a little smarter about which contracts we own and how we roll them over to try to pick up some excess return.

Olly Ludwig: So just to review, give me a bullet-point form of the active variables. I think you’ve touched on three.

Frank Chism: Yes.

Olly Ludwig: Can you lay them out really quickly once again, please?

Frank Chism: Yes, absolutely. So we’re going to put the excess collateral into TIPS versus cash.

Olly Ludwig: Yep.

Frank Chism: We’re going to go out a little bit further on the curve with some of our contracts to pick up a liquidity premium on the commodity side.

Olly Ludwig: Yep.

Frank Chism: And then we’re going to be a little smarter about how we roll. We’re going to do it over more days and not do it on the most congested days that the Bloomberg Commodity Index trades.

Olly Ludwig: Right. Now, you can decline, but you can’t really have a complete discussion about futures-based commodity investing without getting into this notion of contango or backwardation. And don’t run for the door. I’m going to hold you to it.

Frank Chism: I won’t. I don’t think they’ll let me out.

Olly Ludwig: So, yes, let’s talk a little bit about that because basically, at the risk of saying something that our listeners already know about, when you own a futures-based investment, futures contracts expire.

Frank Chism: Right.

Olly Ludwig: So to maintain that index—the Bloomberg index you spoke about earlier—you have to buy another contract so that that continues to fill that silo of your portfolio. You multiply that by 24 different contracts that are all going to be expiring, I mean, it’s a lot of moving parts and a lot of variables in that shift from one contract to the next, right? And that’s where contango/backwardation—can you just open up that Pandora’s box?

Frank Chism: Sure. Well, let me say this first. The most important thing about futures trading is, you have to sell the contract you own before it matures. Otherwise, they’re going to call you and say, “Hey, where would you like this 30,000 bushels of corn to be delivered?”

Olly Ludwig: Good luck with that.

Frank Chism: Like, I don’t know how big your garage is. I live in a row home; I don’t have a garage. I don’t even know how much corn that is. So the important thing is, you have to sell the contract you have, and then you move into the next-month contract. So you maintain constant exposure to that particular commodity, but you do have this rolling mechanism.

So what happens is, in the futures market, each commodity has a future contract going out into the future—hence the phrase. So you have one, normally next month, and then the month after that and the month after that, month after that, etc. They can go out as far as a year. Some are quarterly, etc.

But the basic idea is the pricing mechanism—if you think about “spot price” being what’s the actual price it’s trading at today, then as you go out into the future, the price of the futures will either be above or below the spot price. If the price in the future is above the spot price, we would say that the curve is in contango. And it just means that there’s expected [to be] more demand later, so it’s actually more expensive to buy the commodity in the future than it is today. And that could be inventory reasons or supply-demand imbalances. There could be some benefit to holding the physical commodity.

And then the other side of it is, if the futures’ price is below the spot price, then we consider that to be in backwardation. And so you could actually buy it for cheaper three months from now than you can today. And there’s reasons for that as well, which is maybe it’s a person who’s helping a producer hedge into the future, so the producer is willing to take a lower price than today because they don’t have to think about what’s going to happen three months from now.

Olly Ludwig: So to put a tangible spin on what you just said, in the context of owning this fund, in a contango scenario, a contract that’s about to expire that you sell, again, in a contango scenario, the contract that you’d be replacing it with would be more expensive than the one that just expired. So in some real sense, the returns will be potentially less. In a backwardation scenario, where the contract that’s expiring will be more expensive than the one you’re replacing it with, then, in a backwardation scenario, you would potentially be increasing returns at the margin.

Frank Chism: Absolutely. Right. And ideally, if you ask me today, like, “Frank, got to go buy eight contracts, which one should I buy?” I would say, “Go buy the ones in backwardation, because you’re going to do better on those.”

Generally, what people do is, you try to overweight/underweight on the margins. The things you want to be a little bit underweight, the contango things. You want to be a little bit overweight the backwardated ones, because they tend to help your return a little bit.

But for us with our fund, we’re not really doing so much with backwardation/contango. We’re holding everything in a long-only format. But that’s certainly a part of the commodities futures market structure that, quite frankly, scares a lot of people off because they’re like, “I don’t want to have to explain this.”

Olly Ludwig: You might be scaring me off over here too. I’m kidding. No, but my nerd quotient may be used up for today. But that being said, what else about this fund would you like to emphasize before we call it quits here?

Frank Chism: Yes. Well, I think the important thing that we see is, you know, commodities—when you think about adding commodities to a portfolio, it’s for very good reasons, which are, generally, diversification benefit and inflation protection. So, from our point of view, when we launched the fund, we said we want to make sure that you’re getting commodities exposure.

So when you think about how different our fund’s going to behave from the Bloomberg Commodity Index, it’s probably going to behave less differently than a lot of, possibly, other strategies out there because we don’t want to be so active that you make the correct decision to include commodities in your portfolio, but then the fund behaves very differently than the commodities market when you need it to behave like a commodities market.

So we’re going to have a relatively tight tracking error to the benchmark, and we want people to make a good allocation decision and then be able to have a product that really matches that on the implementation side.

And if we can add some excess return through the strategies we talked about, that’s great. But we want to make sure you’re getting commodity market returns.

Olly Ludwig: Got it. Well, this has been really great, Frank. Thanks for taking the time to talk with me, sharing your insights and your expertise about commodities and about the Vanguard Commodity Strategy Fund.

Frank Chism: Thanks, Olly, my pleasure.

Olly Ludwig: To read the white paper that we referenced in our conversation, called Commodities and short-term TIPS: How each combats [unexpected] inflation, be sure to check out our website. And, remember, you can always follow us on Twitter and LinkedIn. Thank you for listening.

 

 

Notes:

All investments are subject to risk, including the possible loss of the money you invest. The information presented in this podcast is intended for educational purposes only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions.

For more information about Vanguard funds, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

The index we referred to in our conversation was the Bloomberg Commodity Total Return Index.  This index is composed of futures contracts and reflects the returns on a fully collateralized investment in the Bloomberg Commodity Index. The index combines the returns of the Bloomberg Commodity Index with the returns on cash collateral invested in 13-week (3-month) U.S. Treasury bills.

Diversification does not ensure a profit or protect against a loss.

Note that some or all of the income from U.S. Treasury obligations held in the fund may be exempt from state or local taxes. U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

Futures trading is speculative in nature and involves substantial risk of loss. Futures are not suitable for all investors.

The fund’s direct and indirect commodity-linked investments—such as commodity-linked total return swaps, commodity futures contracts and options on commodities futures contracts, commodity-linked structured notes, exchange-traded commodity pools or funds, and other commodity-linked derivative instruments—subject the fund to risks associated with derivatives.

Tax risk: The chance that the fund’s commodity-linked investments could adversely affect the fund’s status as a regulated investment company.

The fund is subject to risks associated with inflation-linked investments. The fund’s annual income distributions are likely to fluctuate considerably. Under certain conditions, the fund may not have any income to distribute. Income fluctuations associated with changes in interest rates are expected to be low; however, income fluctuations associated with changes in inflation are expected to be high. Overall, investors can expect income fluctuations to be high for the fund.

The fund is also subject to interest rate risk, which is the chance that the value of a bond will fluctuate because of a change in the level of interest rates. Although inflation-indexed bonds seek to provide inflation protection, their prices may decline when interest rates rise and vice versa.

The fund is subject to risks associated with subsidiary investmentsIn particular, because the subsidiary is not organized as a mutual fund and is not registered under any federal or state securities laws (including the Investment Company Act of 1940), it does not offer the same investor protections available to shareholders of registered investment companies. In addition, the tax treatment of the fund’s investment in the subsidiary may be adversely affected by changes in the laws or regulations, or interpretations of existing laws or regulations, of the United States and/or the jurisdiction of the subsidiary. The fund’s ownership of the subsidiary subjects it to the same risks as if it were invested directly in the assets owned by the subsidiary.

The fund is subject to leverage risk, which is the chance that any leveraged losses will exceed the principal amount invested by the fund. Returns from a leveraged investment have the potential to be more volatile than returns from traditional stock and bond investments, which exposes the fund to heightened risks.

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