There is a big change taking place in pension plan management. Historically, professional stock pickers were engaged to actively trade the plans’ cash and create returns. Over time, it became clear that the active professional stock pickers, no matter how skilled, had their days in the sun and then had their failures – human nature. Then came indexation, or passive management, where managers oversaw an algorithmic process that keeps the plans’ cash invested without emotion and with less trading. Today the passive approach is gaining adherents while the active approach is falling out of favor as results show the passive approach having greater returns with less volatility.
The evolution in pension plan management predicts an evolution in commodity supply chain hedging. Currently, hedgers embrace an event driven strategy. Commodity traders and brokers analyze the current and near future market circumstances and then recommend strategies to reduce or alter risk. This works well for the most part, but requires a relationship with a “hot” market operator who has figured out the turn of events. This breaks down when the operator begins a cold streak. Then, the hedger must endure sub-optimal results or worse, a period of excess loss, while the market operator regains footing. This complete scenario is analogous to the active professional stock-picker model in both its benefits and detriments.
The comparison to pension plans’ passive approach takes the form of an option-based structure built around a time line. With knowledge of the hedger’s time-related commodity needs, that is its supply chain, a structure is built that employs unique transactions for discrete time periods which are modified by the relation of price to historical price tranches. It appears much like a grid, where position in time and price calls for a pre-determined transaction that is tuned to size of the supply chain at that point in time. Once the grid is employed, then future supply needs turn into nearer supply needs as time passes. This leaves the furthest out part of the grid to be replaced as time passes. Adjustment to the transactions are pre-ordained and are dictated by changes in time, price, and size of supply need.
Use of the passive approach takes the hot or cold operator out of the equation. The hedger is now not event driven, but supply chain driven. If the supply chain is unbroken, the hedge is continually delivering market based price protection in a transparent and predictable fashion.
What are the benefits and detriments of the passive approach vs. the active approach to commodity hedging?
Effect on hedger’s capital structure
The upshot is that just as there are two schools of approach in evolving pension plan management, there are similarly two schools in commodity supply chain hedging. It’s reasonable to expect that the increased predictability and the lower human operator X factor will favor an increasing use of the passive approach in supply chain hedging.