Announcer: Welcome to TDAM Talks, a TD Asset Management podcast. Join us for insights and analysis on current themes and capital markets from our thought leaders. From market insights to investment strategies, we'll help you navigate the complex landscape of investing.
Ingrid: Hello and welcome to TDAM Talks. It's a podcast where we dive deep into the world of investment markets. We're going to share the latest trends, insightful analysis, and cover strategies that are going to help you navigate the complex landscape of investing. I'm Ingrid Macintosh, Head of Global Sales Enablement Marketing and Digital Strategy here at TD Asset Management. And I am thrilled to be joined by some of the sharpest minds in the asset management industry. Today, we have the pleasure of welcoming back two key figures from our Asset Allocation Leadership team, Michael Craig, Managing Director and Head of Asset Allocation here at TD Asset Management, and Hussein Allidina, Managing Director and Head of Commodities. Gentlemen, welcome.
Hussein: Hi, Ingrid. How are you doing?
Ingrid: Excellent. So today, we're going to dive pretty deep on commodities and the role that they can play in a fully diversified portfolio. So, Michael, first, I want to kick things off with you. A couple of years ago, we added commodities to the TDAM capability set. Can you talk a little bit about why it's so important to have this as a tool in your toolbox?
Michael: Yeah, so I won't speak on the investment horizon, which we actually think is quite bullish for commodities over the medium to long-term. But from a pure building a portfolio perspective, commodities have a very unique characteristic, and since they have a very low or even negative correlation to traditional bonds and equities. And so while on their own, they can be quite risky when added to a broad portfolio, because of that negative correlation, they can actually lead to improve Sharpe ratios and a more-- less volatility within a multi-asset portfolio. When we think just having that ingredient, to be able to lower the overall risk of a portfolio, which allows us to take risks in other places, will be a huge competitive advantage for our clients as we move into the future with this strategy.
Ingrid: Can you talk about what led you to Hussein and bringing Hussein on to the team a little bit for some of our listeners who might not have had the pleasure before?
Michael: Yeah, Hussein and I met about four years ago, got chatting, really got into topics about how we saw the world and how it was going to evolve in terms of energy transition, the challenge to bringing new commodities to market, et cetera, and started just spitballing how we might be able to integrate that within a fund complex. And so from that conversation, alongside the evolution of liquid alternatives within the Canadian market, led us to start thinking about how we might be able to bring this to life. And here we are today.
Ingrid: Hussein, can you give me a little bit about your background, where you were before TDAM? And then, I'd love to dive a little bit deeper on commodities, a little 101 and, really, the historical significance of them.
Hussein: Yeah, sure. Thanks for having me, Ingrid. So I joined TDAM a couple years ago from a pension plan in Canada that has a pretty material allocation to commodities. And I think they've had that allocation since the late '90s. So I inherited that and got to develop it. Prior to that, I was in New York. I worked at Morgan Stanley as Global Head of Commodity Research, spent some time at Goldman before that, and then the IMF and the Bank of Canada.
Ingrid: So you know what you're talking about.
Hussein: A little bit.
Ingrid: All right then. So let's have you talk about it a bit. Let's talk about the historical significance of commodities and how they've played out, really. And I think you've been on more of an institutional landscape there. But maybe give us a bit of that background.
Hussein: Yeah, so commodities, I think, are quite important, not only from a portfolio construction point of view, but if you think about the global economy and how the global economy works, it operates, commodities are integral to that functioning. Energy in particular is a very meaningful component of everything, frankly. And for that reason, commodities play a very important role in the outlook for growth. It impacts geopolitics. I have a bias. But I think they're extremely important. In the context of portfolio construction, Mike spoke about the diversification benefit that commodities provide. Another reason why folks look to commodities as part of their portfolio construction is because of the inflation protection that they provide. If you look at the cross-section of assets that you can invest in, most assets have a negative beta to inflation. They underperform in inflationary environments. Commodities, oftentimes because they're the source of inflation, tend to have a positive and very significant beta to inflation. So that's another reason why folks look at commodities in addition to the diversification that Mike spoke to.
Ingrid: We speak largely about commodities, people think about metals and things. What is in the scope of commodities? Maybe just for our listeners who aren't as familiar, what falls in that basket?
Hussein: Yeah, so if you look at typical or traditional commodity indices, they include energy, so your crude oil, your petroleum products, your gasoline, your diesel, includes natural gas. In the metal space, as you mentioned, there's copper, zinc, aluminum, nickel. You also include precious metals in many of these indices, so gold, silver. Some of the indices will include platinum palladium. And then, your soft and ag commodities, sugar, cotton, coffee, cocoa, corn, soybeans, wheat. I'm surely forgetting a couple. But broadly speaking, commodities are the things that you and I consume on a daily basis.
Ingrid: Don't forget pigs and cows.
Hussein: Pigs and cows as well.
Ingrid: Talk a little bit carbon credits as well.
Hussein: Yeah, so carbon is actually not, yet, part of like the S&P GSCI Index or the Bloomberg Commodity Index. But carbon is very much a commodity. We have a carbon fund, as you know, that trades carbon ETFs or ETFs in Europe. And increasingly, you're seeing open interest and volume in these markets pick up as carbon is being priced globally.
Ingrid: So we're hearing about the diversification benefits. Michael, I'm going to pivot back to you. As Head of Asset Allocation here at TD Asset Management and when you think in a global macro context, is it now more important than ever that we should be thinking about commodities as an investing strategy?
Michael: Well, so right now, we're sitting 3/4 of the way through 2023. Really, most investors today, outside of the last year, have been operating in an environment where really the only thing that really changed was growth. So growth will bounce around. But we are in an environment of disinflation or low inflation. Really, this was the aftermath of the financial crisis, where you went through a period of balance sheet repair, which tends to lead to slower growth and less consumption. And so investors have really been thinking, in that world, bonds and equities tend to perform quite well. And I would argue that what has changed is that volatility of inflation, for a variety of reasons, is-- has moved higher on a short-term basis, but will likely stay high on a longer term basis, which means that, all of a sudden, now we need to start thinking about not only the ebbs and flows of growth, but the ebbs and flows of commodities. And when we think about multi-asset solutions, it really changes the dynamic of the ingredients you need to be successful in that world. 2022 is a year that both bonds and equities were down double digits. Whereas, commodities as a broad index were up double digits. And it's exactly the type of year that we're mindful of, that we want to make sure that we have a playbook with the ingredients to be able to be successful in these more challenging worlds where inflation is more volatile. On the near term, with interest rates as tight as they are, I wouldn't be surprised to see inflation moderate. But we are going to be back into positions where aggregate supply will not be met to be able to meet demand because, for a variety of reasons, geopolitical climate demographics and government policy, as well as near-shoring. So therefore, this batch, I believe, really points to quite an optimistic position-- future for the commodity markets.
Ingrid: I think, just really important for our listeners to understand, here at TD Asset Management, the toolbox is quite broad. But equities, fixed income, real assets, so private debt infrastructure, real estate mortgages, and now commodities as well in the mix, it truly gives you a very full toolkit, if you will, to try and navigate as many environments as you can.
Michael: Incredibly deep toolkit. There really isn't-- as I sit here right now, there isn't a particular area where I say, oh, I wish we had-- were able to do that. We have a pretty large and diverse amount of ingredients to use to build portfolios for our clients. And those clients, remember, the solutions that we're trying to solve for are clients who are trying to build wealth, clients who are trying to maintain wealth, and clients who are living off or decumulating their wealth. So it's not just a one--
Ingrid: Inflation is really something you have to outrun in all of those.
Michael: And inflation affects all those people. So inflation is a very, very dangerous factor when it starts to become more volatile for clients. And we have to think about how we're going to face that. And I think through both what Hussein was saying and what our work has shown, it is ultimately the best ingredient to use when inflation starts to move higher.
Ingrid: Hussein, and we're talking, really, theoretically here about the power of commodities, how they might work, can you give us and our listeners some examples of where an investment in commodities was really effective?
Hussein: So outside of Mike's reference to the performance of equities and fixed income last year, the addition of commodities in that scenario would have been quite beneficial. I think part of the reason that my last shop, the pension plan, has this investment in commodities is because there are environments where economic growth slows and/or inflation is higher than expected. And most of the assets in your asset allocation underperform. Commodities, the exception. I think Mike's talked about the diversification benefit of commodities, the inflation benefit of commodities. Both the need for diversification and the need for inflation protection have not been a feature of the market over the course of the last 15 or 20 years because inflation was low. You had low correlations between fixed income and equities. I think if there is uncertainty in the coming years and there's reasons when we look at the evolution of what's happening globally to suggest that you might have more inflation volatility, the importance of commodities grows. So what was a tailwind-- or sorry, what was a headwind for commodities over the course of the last 10, 15 years, ignoring the fundamentals of commodities themselves, but just from a more macro, I think, becomes a tailwind in the coming years.
Ingrid: Can you talk about some of the other themes that we're seeing that might be important in the construct of commodities? I think about the movement into electric vehicles. I think about climate change. Can you talk a little bit about that?
Hussein: Yeah, so that's a really good question, Ingrid. So geopolitics are always very important. I don't think that's a new thing for commodities. But you mentioned energy transition and climate change. And I think that when you look at the data and the challenges that we're going to have from moving from the environment that we're in and that we've created over the course of the last 150 years to the newer greener environment, it requires a tremendous amount of commodities. So if you think about electric vehicles, not only is there a greater proportion of copper and nickel in an EV relative to an ICE vehicle, but you also have to think about the infrastructure that's going to power those EVs. And I don't think that conversation is as versed as it should be. We have to build power generation capacity. We have to build the ability to transmit that power. That's all very commodity intensive. At the same time, although some believe that oil demand is peaking, I'm not in that camp, at least not in the next five, 10 years, the supply side is tightening materially faster than the demand side. So you're going to have challenges, again, because of energy transition, because of the climate, in maintaining oil supply at the same time that demand continues to grow. We're not leaving the demand side as fast as we're leaving the supply side. So I think that energy transition, climate theme is going to be a very important and unique feature of this cycle that we haven't seen in prior cycles.
Michael: And there's the transition theme. And then, there's the more, just, rebuilding infrastructure to withstand a more challenging climate as well. And I think you see this constantly with more and more volatile weather and the need to retrofit buildings to be able to-- whether it be less power, use less power, or be able to withstand more severe climates. So you're getting this almost perfect storm, if you will, for the demand for commodities.
Ingrid: No pun intended on El Nino there.
Michael: No, pun intended.
Ingrid: No.
Michael: And really-- but on the on the supply side, Hussein will be more of an expert in this, but there really isn't any new supply coming on that's really going to be able to meet this increased demand. So this is why we think there is going to be a lot more inflation volatility in the years to come. This is not a comment on the next three months or next six months, but on a more of a-- on a five to 10 year view.
Ingrid: I think we're covering it from both sides. The diversification benefits, we think about it very structurally. But certainly, all of our listeners are often thinking of, what's the great next investing theme? And are we at an opportunistic moment? So with that, I'll take a bit of a sidestep here. At the time that we're recording this podcast, we're just on the eve of launching a new investment strategy to the marketplace, the TD Alternative Commodities Pool. Can you tell me a little bit more about that strategy and how it would be unique relative to other investment opportunities out there?
Michael: Well, first off, we've done lots of market intelligence. We are creating a new category. There's really no formidable competition in this space. The timing is ideal, really, because, to get more technical, we don't actually buy a barrel of oil or a roll of copper. We use the futures market. And we have to-- and so when we do that, we hold cash as collateral. So the nice thing about the strategy is with treasury rates today at 5%, we earn 5% from the-- on the short-term treasury market. And we don't think it's going back to zero. We might see cuts next year. But I don't think that we're back to the zero rates that we saw in the previous decade. So we're going to always have that--
Ingrid: We're already starting at a GIC rate of zero. Worst case scenario.
Michael: Well, that's where we start. Yeah, for sure. And then, the ability to harvest both yield and return from the commodity markets, I think, creates a really unique strategy within our solutions. And when we go through the work about, how do you fund this? If you're going to buy an asset, you have to sell something if you don't have cash. It's interesting because our work points to both a mixture of both debt and equity in order to optimal portfolios, depending on the time horizon, the risk preferences, of that particular client. So yeah, super excited about how that plays out and just being able to have that additional carry because of the high levels of short-term interest rates.
Ingrid: Yeah, I want to dig a little bit deeper on that one. As an asset allocator, you have series across the risk continuum. And I think what I'm hearing from you is that it depends on the stated goal of that strategy how you might use the commodities as an allocation. Can you get a little bit more prescriptive in terms of that debt equity piece and what it might replace in different spots on the risk continuum?
Michael: Yeah, broadly speaking, for more conservative investors, you tend to see more funding through fixed income. For more aggressive investors, just because they tend to have more equity, you see more funding with equity and optimal allocations between 3 and 5%. The challenge for wealth professionals when using commodities is on their own, they are volatile. And so it really is about educating your client and saying, look, there will be years where this is going to not work. And in those years, your other assets will likely perform. There are years when those other assets won't perform and commodities will. And so making sure there is an education process in realizing what the place it has in the portfolio versus the uniqueness of the assets--
Ingrid: Right. The negative correlation piece. So you're not just saying, oh, this was down this year so that was a bad choice because it was probably doing something else in your--
Michael: Monday night, I made Thai noodle chicken soup. It was delicious. One of the ingredients is fish sauce. And if you ever smelled fish sauce, it's awful. But it is an incredible ingredient into that overall recipe. And I think-- not that commodities smell like fish sauce, but I think that analogy hopefully gives you a sense of the importance--
Ingrid: Uranium might. Lithium might.
Michael: --of the importance of the asset. But sometimes, there will be periods where it will be uncomfortable. And this is where you really need to be-- the client has to be focused on long-term goals in the overall mix of assets versus saying, well, my god, let's just buy what's working because, typically, when you chase returns, it is almost a typical sure way to destroy wealth. And so that is where there will be challenges because this asset can be volatile on its own.
Ingrid: But it really takes you back to some of your earlier comments as at any point in time, there is not just one goal of an investment portfolio. You are building wealth. You are sustaining wealth because you've got a big enough nest egg or you're trying to figure out how to optimize the decumulation or the drawdown of that wealth. Hussein, I just want to ask you a little bit. As I said, we're launching the commodities pool. And you talked at the outset about the range of investments that fall into that world of commodities. As the funds being launched, what would the focus be? And what are some of the areas of opportunity in the commodity landscape that we'd see represented there today?
Hussein: Yeah, it's a great question. So the benchmark of the fund is a Bloomberg Commodity Index. So we have exposure to 24 commodities. The fund has the ability to go over, underweight, long, short, those commodities. Today, when I look at the fundamental landscape, and this is a comment more about the next three months versus the next two or three years, energy fundamentals, oil fundamentals, look extremely constructive. We've seen material production cuts out of OPEC. Very robust demand globally, both DM and EM. And inventories globally are sitting at very, very tight levels. And this is why, and Mike alluded to this a little bit, this is why the backwardation in the oil curve is pronounced. You have a 5% collateral yield today. But you also have a 10% annual roll yield because the oil balance is so tight. And that 15% comes before any change in the spot price. When people think about commodities, oftentimes, they think, OK, oil's got to go up, or corn's got to go up, or copper's got to go up. If I'm long in order to make a return, those commodities can stay constant. If the curve is in backwardation, I'm collecting the roll yield.
Michael: So, Hussein, today [INAUDIBLE] trade's a 95, give or take, what would be the one year price for oil? So $10.
Hussein: So I'm buying 85. If nothing else changes, that rolls up and it becomes 95. And that's a very, very different reality than what we've seen in the last 10 years, where these markets were in contango or upward sloping. And the shape of the curve, this is important, the shape of the curve is primarily a reflection of underlying inventories. So if you believe, like I do, that inventories over the course of the next many years are likely to stay tight, then I think it's quite fair to assume that you're going to see this backwardation or this positive roll yield. It's not something that is a feature of the market all the time, to be very clear. But in periods where you have a supply/demand imbalance, and we can talk for hours about this, but in periods where you have a supply/demand imbalance and inventories are below normal, you have backward dated curves and positive returns.
Michael: So the reality is that we have lived in a world of abundance. And what the market is telling you, I know this isn't front page news, but what the market is telling you is there's a premium to get delivery of product right now. It's a very different world that we've been-- lived in the past. And it's because of the demands from shareholders not to increase CAPEX because of the inability to bring new products online. And this is where you start to see real tightness and frictions within the overall spot market, which tells you that the demand for underlying commodities is building and building and something isn't quite right in terms of, as we transition from that world of abundance to a world where things are tight and there's not a lot of supply.
Ingrid: And I'm driving these questions so you guys get your geek on because part of the point that I'm trying to drive home here is, in the absence of a vehicle like the commodities pool, how might an advisor even attempt to get this exposure on their own?
Hussein: I think historically, in Canada, folks have tried to get the dirty hedge or the dirty exposure through commodity equities. And if you look, for example, at the correlation between something like XEG, which is an ETF of Canadian energy companies, and oil, you see a relatively high correlation, about 50%. So it's not a bad way to get the exposure. But it's not the same. So if you look at the diversification benefit, it's not the same. If you look at the inflation protection, it's not the same. And very, very important, Ingrid, in the tails and periods of duress, the commodity equities look a lot more like equities than they do like the commodity--
Ingrid: Correlation that you're looking for.
Hussein: So you see that correlation of 50% between the two and you say, OK, it's a dirty hedge. I don't need oil. I can't buy oil. I'm going to buy the energy company. That works on average. But in the tails, when you need the protection that commodities afford, you don't get it from the equity.
Michael: And historically, again, when the commodity prices starts to rise, it tends to-- companies would go and extract more and you get that operational leverage, I don't think that is pronounced today as it used to be, again, because of ESG and constraints in terms of bringing more product to market. So in many ways, by buying the commodity, you don't take on the operational risk of-- running an oil company or running a mine are really, really complicated businesses. If you think about how hard it would be to run a mining company or oil, global oil energy company, it is like 3D chess times 10, really challenging businesses to run.
Ingrid: You're saying this to me because you know my husband is a geologist who runs mining companies. I get it.
Michael: It's every day.
Ingrid: I live this every day.
Michael: And so in many ways, the commodity, it just is the pure play on that rather than having to take on all that extra risk. I'm not saying-- there is always a place for these companies in a portfolio. Don't get me wrong. But for what we're trying to solve for, it's a very different use case than buying a straight equity.
Ingrid: And hoping for it to go up. There's so many other sources of return. Gentlemen, this has been a fantastic conversation I think we've educated our listeners on what commodities are. We've identified how to think about them in a portfolio. We've separated away that view in terms of, it's just not a buy an asset that goes up, but there's so much more to it, and really highlighted that it's truly a great time to be investing in commodities. Thank you so much for joining me today.
Michael: Our pleasure, Ingrid. It's been great to be here.
Hussein: Thanks for having us.
Ingrid: And to our listeners, for more great commentary and thought leadership, including some of our more recently published asset allocation perspectives, please visit the Insights page on TD Asset Management's site. And you can always get latest expertise and updates from us on LinkedIn at TD Asset Management. Thanks, everybody. And have a great day.
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