Assessing views on commodities
Fons Lute, chief investment officer at Blue Sky, the fiduciary manager of several pension funds including that of KLM and has an AUM of €12bn
From a tactical rather than a strategic point of view investing in commodities can be worthwhile. The strategic benefits are not as pronounced as asset-only studies often claim, based on the low correlation between commodities and other asset classes. In an ALM context, the benefits are less obvious.
None of our clients is currently investing in commodities. We do not advise them to do that strategically. And some clients don't find it appropriate to place tactical asset commodity bets without commodities being part of the strategic benchmark.
Investment in commodities from a strategic point of view is alpha generating and can affect the liability streams of pension funds. With a strategic asset allocation, investors assume positive long-run returns, in other words higher commodity prices through time. This is not necessarily true. Real commodity prices have been downward sloping rather than increasing. The inflation component can be rewarding. That would make commodities interesting for pension plans, since inflation is certainly one the biggest risks on their balance sheet. From an ALM perspective, however, commodities are less of an ideal inflation hedge compared to inflation-linked bonds. Therefore, the biggest risk of a pension plan is better captured by investing in inflation-linked bonds.
Looking forward, we are very sceptical about the returns of commodities. Many investors are attracted by roll return from backwardation. Past returns have shown backwardation indeed, but that does not imply its future prevalence. On the one hand, increased supply of insurance by investors will lead to diminishing insurance margins. Scarcity of commodities on the other hand will reduce the need for commodity producers to insure their future deliveries. Therefore, backwardation may well be a feature of the past rather then a prescription for the future. The contango situation of the past two years may be the first proof of such a change in market fundamentals.
Looking at the spot return, it is also important to bear in mind how quickly commodity prices can change. Oil prices, for example, have been quite favourable for investors over the past couple of years due to geopolitical developments such as a sharp increase in demand in China and India, production shortfalls in Iraq and worries about the security of supply from Iran.
But if the world continues to reduce the energy intensity of goods production, the expected scarcity of natural resources such as oil may be less pronounced than many people seem to expect. In that case the short run spot returns will still be cyclical, but in the long run it will move sideways at best. Altogether, we conclude that commodities are interesting tactical plays but that their strategic value is debatable.
Thomas Ekeli, investment director at the Norwegian Government Pension Fund, which has AUM of NOK1,891bn (€221bn)
Our pension fund consists of two parts: the Pension Fund Global, formerly the Petroleum Fund, and the Pension Fund Norway, which used to be known as the National Insurance Scheme Fund. The latter is now a closed fund: it has no outflows and no inflows apart from its own returns.
The Pension Fund Global is the larger. Its inflows consist of the state's petroleum revenues, as well as the fund's financial return, while the outflow is the sum needed to balance the fiscal budget. It is thus fully integrated into the state budget, and the net allocations to the fund reflect the total budget surplus including petroleum revenues.
The accumulation of assets in the Pension Fund Global can be seen as part of a transformation of assets, where the state is selling physical petroleum in the North Sea - a commodity - and exchanging it for financial assets. This is why the fund is not investing in commodities as a way of diversifying risk for the state. Instead, Norway is reducing the energy price risk and building a more diversified portfolio, away from commodities.
Our assets under management still total only half of the estimated value of our petroleum reserves. So there has not been a strong drive to allocate large portions to energy or commodities.
Norway found oil in 1969 and production started in 1971, but the big accumulation of financial assets in the Petroleum Fund only started in 1996.
It was then decided to invest 40% in international equities and 60% in international bonds. The regional distribution of investments has so far been around 50-60% to Europe, a third to the US and the rest in Asia. We do not currently have any allocations in alternatives. However, we have regular reviews of the investment strategy and will be considering real estate and private equity.
We have just completed the latest review, and the finance minister has announced an increase in the equity allocation to 60%. The government feels that a 60% equity share today is an appropriate trade-off between expected risk and return.
We have proved that we are able to live with the volatility in equity markets over the past decade without changing the investment strategy or the fiscal policy framework.
The real return of the Pension Fund Global with our current asset allocation has been 4.6% over the past 10 years, which is above the 4% benchmark for the expected real return as formulated in the fiscal policy guideline.
The benchmark is composed of the FTSE indices within the different regions on the equity side and Lehman Brothers global aggregate bond indices on the fixed income side. We give our manager, the central bank Norges Bank, a tracking error risk limit of 1.5%. It has positively contributed to the returns with an annual average 0.5% excess return in the past 10 years with only moderate risk. So while near index management is a core emphasis of the fund, we are pleased with the level of excess returns.
While we don't have commodities in the fund's strategic benchmark, I should mention that energy and commodity derivatives are in the investment universe if needed.
We note that commodities have historically been fairly volatile and have produced only moderate returns, so for us it makes sense to continue to diversify away from petroleum. However, I can understand that pension funds with a completely different background may want to diversify with a small percentage in commodities.
Our fund is different from many other pension funds. We have neither a clearly defined liability side - our large unfunded pension liabilities are not legally linked to the fund - nor the type of regulation to which many pension funds have to adhere. And volatility is not an issue for us as long as it doesn't end up influencing the political environment.
Andrea Girardelli, director at Fonchim, the Italian pension scheme for the chemical industry, which has AUM of €1.6m
Currently we don't directly invest in commodities and I don't think we will invest in them in the near future. I don't think it's necessary for pension funds to invest in commodities and I do not think many pension funds are prepared for such investments.
But maybe in the longer-term future, when the normal market of equities slows down, we will consider investing in commodities.
We don't see a need to invest in them as in a normal market our current investments provide fairly good returns and at the same time they possess only little volatility. Commodities, on the other hand, are more volatile and riskier assets.
The only exposure we have to commodities at the moment is through our benchmark, the MSCI World Index, which includes most of the world's equities and is a diversification in itself. We invest in a mix of equities that also includes commodities such as food producers and possibly oil companies. So indirectly through the purchase of indices we do invest in commodities, and these indices will also be affected by rising commodity prices.
But the allocation of uncorrelated assets is up to the fund manager, not the asset allocator. The fund manager has to beat the benchmark or achieve a return. We don't invest in uncorrelated assets such as real estate, as they are too expensive at the moment.
Our current asset allocation depends on the fund. We have three funds: one with 60% in equities and 40% in bonds, the second one with 30% in equities and 70% in bonds and the third one is completely invested in bonds. The return for the bond fund was higher than inflation in the last year at 3.5-4%, while the fund with 30% equities returned 6.5% and the fund with 60% equities returned 10% in 2006. All these returns are reasonable and do not encourage us do invest in other assets such as commodities.
We like investing in bonds because they are less volatile, more liquid and safer depending on the rating of the bond. And equities have given us good returns over the past three years.
I suspect our competitors in Italy do the same as we do - invest in bonds and equities and stay away from commodities.