Investors have debated for decades over whether active or passive strategies work better, particularly when it comes to commodities. As volatile and cyclical as commodities are, the same buy-and-hold strategies that work in stocks aren't always appropriate for hard assets, and the newest indices and funds have evolved to reflect a more active approach.

Ken Armstead is partner and CEO of Absolute Plus Management, an investment firm with two funds, the APM Hedged Global Commodity Fund and the APM Global Fund. Founded in 1999, Absolute Plus Management takes an active approach to the commodities space, using value, directional and dislocation strategies to build a bond/commodities mix that takes advantage of both assets' cycles.

Recently, associate editor Lara Crigger chatted with Armstead about his thoughts on using the active approach for commodities, including the pros and cons of the passive approach, whether we'll soon see more active commodities ETFs and if contango will persist.

Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): Most commodity funds—at least ETFs—are passive, long-only vehicles, an approach that has come under fire lately. What risks are entailed in using a long-only, passive approach to commodities?

Ken Armstead, partner/CEO, Absolute Plus Management (Armstead): Commodities tend to behave in a much-higher-volatility fashion than stocks, bonds or other things. Commodities tend to be driven by short-term supply/demand disruptions, particularly when the market clearing mechanism has to rely on price behavior, because in the short run, most commodity supply is inelastic. So to clear the market, the price has to reflect what it's worth to the marginal buyer or seller. So that's why you get such volatile outcomes over time.

But clearly there are diversification benefits to owning commodities. And the way we think active managers can set themselves apart from passive indexes is by ameliorating the downside risk associated with owning commodities. For the active manager, there are a number of constructs that seem to be available for extracting returns.

Crigger: How is your approach to commodities different than others?

Armstead: We understand there are some basic macro constructs that should hold fairly true over market cycles, such as high real GDP, higher commodity demand, or higher growth demand, and so on.

In the construct of our approach, the idea is that interest rate cycles and commodity cycles tend to be countercyclical, anti-correlated to the degree that you can marry right-tail-skewed, anti-correlated return outcomes that give you a better overall portfolio benefit. Thus, we historically have married active investment processes in bonds with active investment processes in commodities. And thus we see a very different payoff than you would see from a passive index.

Crigger: In fact, your Hedged Global Commodity Fund managed to stay afloat during the big commodities crash in 2008, even as passive indexes like the DJ-UBS and GSCI fell. Why is that?

Armstead: Part of it is in how we manage our risk, which gets back to the idea of ameliorating the downside excursions. Additionally, because we own bonds on the other side, we get benefit from the countercyclicality of those outcomes. 2008 was kind of interesting, because we made most of our money in commodities in the first half, and most of our money in bonds in the second half.

Crigger: Your focus is on the institutional investor, but can the active approach also benefit the retail investor?

Armstead: I think it can be a benefit. Typically the access there could be perhaps through some sort of platform structure. I know some of the wire houses have accessible manager exposure through various platform structures, or the managed account platforms that have developed over the past few years.

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