Commodities are a staple of any diversified investment portfolio, but few investors factor in the cost of shipping them around the world.
Can freight rates provide protection against disruptions to global trade?
This article was originally published in The Business Times on 1 November 2024
The announcement of a massive economic stimulus in China in late September has underlined the appeal of commodities for macro investors, with prices ticking higher on everything from rubber to iron ore.
While commodities are a tried and tested asset class among macro funds, there are other, less crowded ways to take a view on global trends.
The Baltic Dry Index (BDI), a composite index based on daily freight rates quoted for major sea routes, offers broad exposure to a key part of the commodities value chain but is often overlooked by macro funds.
As a benchmark of shipping costs, the BDI can provide valuable diversification – as well as potential for alpha. Even though an uncertain economic outlook has held back individual commodity prices, it’s worth noting that the BDI has more than trebled since early 2023.
What drives the BDI?
Dry bulk cargo accounts for 30% of international maritime trade. Iron ore is the largest category, followed by coal, grains, steel, various other mineral ores, fertilisers, agricultural commodities and cement.
Demand for raw materials and primary goods is the primary driver of dry bulk freight rates. But shipping rates and commodities prices are not always correlated. While a supply shock would lead to a jump in commodities prices, for instance, it will mean there is less to be transported and diminish dry bulk demand.
The dry bulk market will also be heavily influenced by trade policies, geopolitical tensions, and macroeconomic conditions. If US-China trade tensions were to worsen under a Trump presidency and lessen trade flows, demand for dry bulk will drop in tandem.
There are longer-term forces at play, too. On the supply side, improvements in shipbuilding technologies have led to the construction of larger and more efficient vessels, contributing to an overall increase in capacity.
That, along with additions to fleets, has largely kept up with the increase in demand over the past 10 years. But going forward, stricter climate regulations are leading to ships having to reduce their speeds, which could curtail capacity growth by requiring more vessels to do the same amount of work.[1]
So, the BDI is better thought of as a barometer of several interdependent factors: the volume of worldwide trade, manufacturing, and demand for industrial commodities and finished products.
How is the BDI calculated?
Each working day a panel of international shipbrokers submits an assessment of the current freight cost for various sea routes to the Baltic Exchange.
The index derives its value from three subindices, giving a 40% weighting to the first and 30% to each of the other two:
- Baltic Capesize Index (BCI), capturing the freight rates for the largest class of dry cargo ships, known as Capesize because they cannot pass through the Panama Canal, so have to sail around the Cape of Good Hope and Cape Horn.
- Baltic Panamax Index (BPI), covering the next largest class of ships designed to fit through the Panama Canal.
- Baltic Supramax Index (BSI), covering the next largest class.
Historically, the BDI has experienced a lot of volatility during major economic events such as the US stock market crisis in 1987, the 1999 dot-com bubble burst, and the 2008 financial crisis. These crises also affected commodity prices, indicating a plausible causal relationship between the BDI and commodity prices.
There have been many studies on correlation and the forecasting relevance of the BDI. But a key consideration for fund managers is that the shipping market shows little correlation to other traditional asset classes, yet it is volatile and affects virtually every area of the world.
How can this measure be traded?
The BDI itself can’t be directly traded. However, the index’s three underlying components can, by virtue of cleared derivative contracts listed on various exchanges. This allows us to replicate exposure to the BDI by trading futures contracts on average time charter rates on Capesize, Panamax and Supramax routes.
The forward freight market is active, liquid and efficient. As well as allowing ship-owners to hedge against a fall in rates and vessel-charterers to cap the cost of transporting goods, it has a host of other applications, too.
For example, a ship-owner who sees high charter-demand for their vessels may buy contracts to go synthetically long the market as a proxy for chartering additional vessels to meet demand. As the market has developed, specialist shipping funds and exchange-traded funds have also become active participants.
These shipping funds or ETFs, however, typically invest in freight futures alongside listed shipping equities, which may not be suitable for investors seeking direct exposure – for example to balance a macro or commodity section of a portfolio in a more tailored fashion.
“A key consideration for fund managers is that the shipping market shows little correlation to other traditional asset classes, yet it is volatile and affects virtually every area of the world.”
Other investors take exposure to shipping costs by purchasing cargo ships, which comes with the complexities of owning and operating ships.
Whichever way fund managers choose to add shipping rates to their portfolio, the advice of an experienced partner is fundamental to achieving success.
Freight managed funds have the necessary real-world experience to trade in these products. They leverage this expertise to execute appropriate strategies using the individual time charter contracts, or individual vessel routes.
Moreover, the range of products is not limited to just dry bulk, but extends to crude oil vessels, product tankers (engaged in the trade of non-crude oil), LPG tankers and container ships. This provides a wide asset spread that has seen remarkable returns in the wake of the Russia-Ukraine crisis.
Astute macro funds already have their sights set on the shifting demand profile for commodities resulting from the emergence of new engines of growth, ranging from the rise of fast-growing regions like Southeast Asia to the acceleration of decarbonisation.
They will also be cognisant of the array of geopolitical issues that could put a crimp in various markets. What is often missing, however, is specific exposure to the seaborne trade that delivers those commodities and potentially alpha along the way.
[1] https://public.axsmarine.com/blog/bulk-carriers-fleet-growth-a-decade-in-review-and-2025-outlook