22 MAY, 2023
By Toby Hayes
In 1923, John Maynard Keynes was analysing commodity futures markets when he noticed that the costs of commodity storage, which were often very high, were baked into futures pricing.
He observed that speculators invested in commodity futures would not only receive the commodity return but would also be paid the storage costs on top. Keynes had discovered the first structural return – a return source embedded within a traditional asset class that is independent of the macro risks driving the market.
Even Keynes did not fully understand the importance of what he had discovered. It took 85 years before the concept of structural returns became embedded in the financial lexicon. Structural returns are unique and quite idiosyncratic, which makes them hard to define as a homogenous group.
However, their defining characteristic is that their return profile is independent of traditional risk factors (Fed policy, pandemic response, earnings, etc.). Instead, it is driven by factors that are specific and unique to the market in question, such as regulation, seasonality, index rebalancing, and credit rating slippage.
For example, let’s consider a variant of the Keynes conundrum and the behavior of a commodity ETF tracker versus the physical commodity price index. In certain conditions, two structural returns can work against the passive ETF holder. One of these is the ‘congestion effect’, a structural phenomenon in any market that has been touched by the rise of passive investors.
As Keynes surmised, the storage of commodities is expensive, so investors typically invest via the futures market. However, as futures expire with time, all investors must periodically roll their position in order to maintain exposure. Every month, passive money buys the nearest futures contract, holds the position for a month, then sells just before it expires to buy the next one out on the curve.
This ‘rolling’ on the commodity curve maintains the constant exposure (beta) to the commodity market. Because all passive money has to follow the same index-tracking rules, $150bn tries to squeeze in and out of the same contracts at the same time every month.
This causes price distortions that passive investors have to swallow, leading to structural underperformance of the ETF tracker versus the commodity market. This is where the structural investor comes in. Index roll schedules are published well in advance and it is clear that by selling the front contract and buying the next contract a few days before the index money invests, one can profit from the price squeeze. What is effectively a congestion fee to the passive investor becomes a persistent return stream for the structural investor who prepositions for index flows.
Congestion and similar crowding effects are everywhere passive money goes. However, these distortions also extend well beyond the influence of the passive investor.
Indeed, in any market where large non-price-sensitive agents operate, structural anomalies arise and can be monetized. One recent example of this phenomenon is the frenetic trading activity of online retail investors, desperate to cash in on the latest meme stock.
Their herding behavior has created predictable, monetizable rebalancing flows from levered tech ETFs, following speculative flows on the way up and down. While such distortions clearly make little fundamental sense, the structural investor is agnostic, seeking only to profit from the anomaly while avoiding the market risk.
Structural returns monetize market anomalies, without taking market risk. The principal risk to the structural investor is therefore that the anomalies dissipate. Fortunately, forecasting when and where a structural return may come or go is not necessary.
The structural investor seeks only to identify the return and be proactive to move through different return sources as they come and go. While the trade is not risk-free, the risks are particular to each market and unrelated.
If an unexpected rule change were to happen – a commodity index rebalancing at the same time as equity indices, for example – it would be coincidence not correlation. Likewise, traditional economic risks do not play into it, and herein lies the key benefit of structural returns within a traditional balanced portfolio: the art of diversification.
Statistical correlation is not a good metric to assess how a portfolio will fare in a stressed environment; correlations are neither stable nor accurate. With asset classes pushed to stratospheric valuations by central bank intervention, how confident can one be that bonds will protect a portfolio if confidence in central banks falters?
How does the traditional balanced portfolio behave in an inflationary environment? These questions are too significant to be left to the vagaries of a historical correlation statistic. This is where structural returns shine. Correlation statistics confirm their diversification credentials, but the diversification goes deeper.
There is no one ‘event’ that hurts all structural returns simultaneously. Their ability to diversify is fundamental, not just statistical. In this regard, they are unique in finance and deserve an essential place within a balanced portfolio. In many ways, they are the only true alternative return.