COLLATERALIZED COMMODITY FUTURES

COLLATERALIZED COMMODITY FUTURES

Methodology Overview

TABLE OF CONTENTS

OVERVIEW..................................................................... 1

What is This Document?...................................................1 Time Horizon.......................................................................2 Model Changes...................................................................2

COLLATERALIZED COMMODITY FUTURES....... 3

Asset Class Overview ....................................................... 3 Expected Return Methodology.......................................4

Yield: Collateral Return + Roll Yield............................5 Collateral Return.....................................................5 Roll Yield...................................................................6

Valuation Change............................................................8 Rebalance Return .........................................................10

Results.................................................................................. 11 REFERENCES.............................................................................................................. 13

REVISION DATE: 7/1/2015

What is This Document?

OVERVIEW

"We understand that some of our insights will never find their way into products, but we provide them in support of investors and the finance community."

-- ROB ARNOTT

CHAIRMAN & CEO

This is one in a series of plain-language white papers setting forth Research Affiliates' building block approach to developing long-term capital market expectations by asset class. (For information about the objectives and guiding principles of our asset allocation initiative, please refer to "Capital Market Expectations: Methodology Overview," the first of these white papers.) In working out our risk and return forecasts and making them publicly available, we keep three criteria in mind: transparency, robustness, and timeliness. By describing the conceptual framework and calculations behind the projected asset class risks, returns, and correlations in these papers, we hope to achieve a meaningful level of transparency without excessive details. By constructing simple, economically sound models for major asset classes, we strive to achieve a fitting standard of robustness for forecasting to a 10-year horizon. By initially refreshing our expectations on a quarterly basis, we seek to provide information that is updated with useful frequency. We will continue to refine our methods, extend the scope of our capital market expectations, and improve this documentation over time.The remainder of this document addresses how we think about asset class risk, and provides transparency into the methods employed to develop these risk forecasts.

COLLATERALIZED COMMODITY FUTURES |1

Time Horizon

One of the major considerations when embarking on the journey to generate asset class return expectations is the consideration of time horizon. Because the focus here is on generating capital market expectations for strategic asset allocation, and not tactical overlays, we selected a 10-year time horizon. The 10-year time horizon, is not meant to imply a 10-year buy-and-hold strategy, but instead incorporates a strategy consisting of asset classes each with a constant duration target. Said another way, asset classes with shorter durations (e.g., fixed income), need to be periodically rebalanced to maintain a constant duration. The rebalance period chosen is 1-year which means that a 2-year bond, for example, will be held for 1 year, at which time the 1-year bond will be sold and the proceeds used to purchase a new 2-year bond. Asset classes with significantly long duration (e.g., equities), can be considered buy-and-hold because the change in duration from the passage of 1, 2, or even 10 years on these types of assets is minimal.

Model Changes

The current update to Q2 2015 capital market expectations includes some modifications to our model for commodities. As we've stated since the launch of our Asset Allocation site, we are continually doing research into ways to improve our models and will share applicable findings with you. The major model changes address the steady-state level of roll yields and the speed of mean reversion captured in the change in valuation buildings block. After further research, we've observed that roll yields have been consistently dropping over time and the rolling 10-year average is a better steady-state value than the longer trend used in the previous model. In addition, when looking at commodity indices, the choice of contracts affects the amount of roll yield that can be captured. For example, the Bloomberg Commodity Index invests strictly in front month contracts, and in general, the slope at the short end of the term structure is steeper than with longer maturities. Therefore, because we measure individual commodity roll yield based on the entire term structure, when calculating roll return for an index, we provide an offset to capture the specific contracts selected by each particular index. Finally, in further analyzing the reversion of commodity prices, we see that commodities tend to revert at a faster rate than previously calculated. Thus, in the updated model, prices fully revert to their average price over the subsequent 10-year period. With these changes, the expected returns at an index level are actually very similar to those in the prior model. This result, however, is mere coincidence; we believe these changes make the model much more responsive to changes in the markets.

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