The S&P GSCI paved the way for three decades of index innovation in the commodities market and is the most widely recognized commodities index benchmark, just as when it launched in April 1991. While 30 years is a lifetime in commodities investing and there have been a number of marquee index-based solutions brought to market over this time, we anticipate that the next 30 years could bring even more disruptive changes to commodities market. Here are five trends that could become ascendant for the years to come:
Incorporating ESG metrics
Investing in commodities poses meaningful challenges for investors looking to incorporate environmental, social, and governance (ESG) metrics into their investment criteria. As a start, commodities are a broad and diverse asset class with different financial, environmental, and social implications. While it may be possible to apply carbon footprint and ESG risk metrics to underlying commodities, and by association to commodities derivatives, such sustainability metrics have not been developed with these financial instruments in mind. Financial participation in commodity derivatives markets does not directly influence a particular company’s actions, as it can with equities or bonds, nor, arguably, does it come with the ability to affect the underlying spot commodity price. This makes applying ESG principles difficult.
Nevertheless, the main objective of commodity derivative markets is to facilitate risk. This objective aligns with many of the principles of ESG, specifically the need for transparency, risk mitigation, and market access. For those market participants looking to adapt existing ESG metrics to commodities, environmental issues will take centre stage as arguably the most pressing and directly relevant ESG pillar. In such cases, the carbon footprint of various commodities can help inform ESG-minded decisions. Using lifecycle analysis (LCA) databases is a relatively straightforward approach to computing carbon footprints of individual commodities, and such metrics can likely be integrated into index methodologies.
Since we cannot live without commodities, commodities market participants should advocate for more efficient and sustainable production and usage, but the commodity ESG conundrum will not be an easy one to solve.
Tactical allocation against rising inflation and development of green technology
As the broad cohort of market participants becomes more sophisticated and access to alternative asset classes improves, the tactical allocation to individual commodities could be set to expand. Two current market trends may be interesting to see through a commodities lens: the post-Covid recovery and associated inflationary pressures and the growth in green technology.
For many market participants, unprecedented and coordinated fiscal stimulus in the wake of the pandemic has justified concerns over inflation. Historically, commodities, and in particular gold, have demonstrated a high inflation beta and may provide a suitable inflation hedge. Commodities have historically had higher volatility than most other asset classes over the short and long term. It may not take a lot of exposure to either a single-commodity index or a broad-commodities index to reap the benefits of inflation protection.
Technology used to mitigate or reverse the effects of climate change is expected to play a vital role in the near future. Besides rare earth metals, the building blocks for many of these technologies are industrial commodities such as copper, aluminium, nickel, and silver. According to a recent World Bank Group report, over three billion tonnes of minerals and metals will be needed to deploy the wind, solar, and geothermal power, as well as energy storage, required for achieving a below 2C future. Technology has worked against commodities historically, but in the case of decarbonization, the adoption of green technologies signals strong demand for many commodities.
Growing adoption of non-traditional data
The commodities market is ripe with data, from the traditional supply and demand metrics reported by government agencies on a regular basis, to real-time data, such as port inventory that can be computed using satellite imagery. Finding ways to use this largely non-price (or non-financial) data in rules-based, investable indices can present attractive opportunities.
The scale and scope of non-financial data available in commodities markets is unique. Yet processing and modelling that data to produce investable signals with attractive risk/return profiles on a large scale has proven difficult. However, a new generation of commodities indices utilizing supervised machine learning to compute large non-linear datasets to generate investable signals may be on the horizon.
This approach could also offer a solution to incorporating ESG data into commodities indices. For example, S&P Global Platts announced its intention to develop AI-driven physical carbon credit price assessment indices in February 2021. The new price assessments will leverage environmental AI expertise provided by Viridios Capital, which has been trained on over 20,000 data points, representing transactions from across the range of carbon projects around the world.
Disruption by cryptocurrencies and tokenization
Cryptocurrencies and digital ledgers may be both an opportunity and threat to traditional commodities derivatives markets and commodities indexing. As an alternative asset class, certain cryptocurrencies could offer diversification and inflation-protection benefits similar to commodities, particularly gold. As an investment vehicle and store of value, a limited history, extreme volatility, and weak regulation present challenges today, but there is no doubt that cryptocurrencies are beginning to play a more important role in investment portfolios. Some cryptocurrencies that currently operate as speculative assets will likely begin to shift to a demand-driven market based on demand for the underlying utility, essentially giving them additional commodity-like characteristics.
The tokenization of real assets may create further competition for traditional derivatives-based commodities investment instruments. So-called digital gold is already disrupting the retail gold investment market. Tokenization may also play a role in improving the allocation, measurement, and transparency of non-price characteristics of commodities and real assets, such as carbon intensity.
Digital ledgers and tokenization may disrupt and potentially improve the efficacy of risk management for physical commodity hedgers. The network of digital ledgers that are used to record transactions could improve the management of price and counterparty risk inherent in commodities production, trade, and consumption. It is anticipated that all trading ecosystems will be digital within the next few decades, including traditional exchanges.
Implementation of alternative risk premia strategies
Investors are becoming well versed in using alternative risk premia to efficiently measure, isolate, and gain access to alternative sources of return through rigorous, liquid, and transparent rules-based indices across asset classes. In the commodities market, concepts such as carry have a strong economic rationale, while the underlying commodities themselves exhibit low correlation to traditional asset classes and are traded in liquid derivatives markets. The prevalence of non-profit-seeking participants in the commodities market adds to their attractiveness. Momentum, Carry and Curve are three widely accepted risk premia that will continue to be enhanced and applied to the commodities market.
Fiona Boal is head of commodities and real assets at S&P Dow Jones Indices.