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Bullish on commodities

IPE asked three pension funds in three countries – the Netherlands, Portugal and Switzerland – the same question: ‘Do you agree with investment guru Jim Rogers that commodities are the only pure bull market in the world?’ Here are their answers:

Vera Kupper Staub, CIO of Pensionskasse der Stadt Zürich, the pension fund of the city of Zürich which has assets under management of CHF11.76bn (e7.6bn)
“We hold 2.5% of our portfolio in commodities but we don’t do any tactical allocation within asset classes. Consequently, we don’t have a tactical view on commodities and so if we do not make any strategic changes will always stay with 2.5%.
“We invest in commodities on a strategic basis because we expect them to be a good diversifier. As an asset class it is a good risk, or crisis, hedge. It reacts positively to one type of crisis that is very negative for equities and equities are still our main risk in the portfolio. So the inclusion of commodities improves the crisis properties of the fund’s portfolio.
“But commodities not only show attractive crisis properties, but also a low to negative long-term correlation with equity returns and all our other asset classes as Swiss and foreign currency fixed income, real estate investments, private equities and hedge funds.
“Although the volatility of commodities is huge - in most of the years that we have invested in commodities they were either the top or bottom performing asset class - they have a volatility-reducing impact on the total fund’s return volatility. This is the positive impact of its correlation characteristics. However, this positive impact vanishes when the share of commodities becomes too big.
“We don’t have a specific view on the future evolution of commodity prices. Consequently, we don’t expect either a bull or a bear commodities market. The limited availability of natural resources is a potential argument for a bull market but the broad possibilities of substitution and productivity improvements are counter arguments.
“For us commodities are not a high-return asset class. The return we expect over the long term is something more than that from international fixed income, say an additional 1%. We expect this premium, known as backwardation in the futures market, to persist on average as it is our remuneration for our risk taking.
“Last year the Swiss franc return of our 2.5% of commodities in the portfolio was roughly 12%. The total fund’s return in Swiss francs was 6.8%. So in the past year commodities clearly made a positive contribution.
“Our allocation to commodities is implemented via a commodities fund which replicates the Goldman Sachs commodity index. We decided to use the Goldman Sachs index because its weightings are based on world consumption. With the resulting sensitivities it shows, in our view, the best commodities crisis hedge characteristics. The index replication within the fund is generally passive, but it tries to add value mainly through a smart rolling behaviour.”

Jelle Beenen is head of commodities and quantitative strategies at Dutch health care sector industry-wide pension fund PGGM, which has AUM of around e62bn
“There are certainly reasons that could support a bull market in commodities. The most important is the reduction of the spare production capacity so the markets, and particularly the energy markets, cannot react to either spikes in demand or eventualities where a crisis affects production – like in Iraq, a strike in Venezuela or unrest in Nigeria – by swiftly tapping into extra production. So the only way to respond is by price movements.
“And that is a central theme. It is not something that can be resolved within one or two years. New production infrastructure certainly needs between two and five years to become operational.
“But the reason we are in commodities is not so much linked to whether there is a bull market right now or not. Rather, our strategic reasons for being in commodities are that we cannot predict when there will be a bull market in a particular asset class. We are in there because we want to balance the eventuality that a bull market develops in commodities, as it would be very detrimental to our returns from other assets.
“So, as a pension fund we don’t have a particular view of the market. We started to invest in commodities in 2000, long before a lot of institutional money started to flow into the asset class, with 4% of our portfolio, and we are now approaching 5%. This is not that much in assets, but commodities are very volatile so the amount of risk a 4% commodity allocation implies is roughly equal to the risk of a 30% allocation to fixed income.
“Our motivation was to have a well-balanced mix of assets. There are two considerations that are widely cited as the advantages of commodities – a positive correlation with inflation and a negative correlation with other assets. But while the link with inflation should help to better match our liabilities, as they are linked to inflation, we found in fact that this effect was limited, because if you want to reduce the inflation sensitivity of the whole fund you have to make a pretty big commodities allocation, so 4% would not help that much.
“However, a 4% allocation goes a very long
way in reducing the overall volatility of the asset mix because of the negative correlation. We found that a 4-5% allocation to commodities already substantially reduced the overall volatility of PGGM’s total asset mix because commodities tend to perform very well when other assets are performing badly. Typically those times are either when economies are overheating or at a time of geopolitical risk.
“During overheating commodities prices are supported by a high demand to keep the industrial processes going, but at that time equity markets are already realising that prices are at the top and the only direction is down. Geopolitical risk, such as the trouble in the Middle East and the Iraq war, are not in general helpful to most assets, however energy futures have had a tremendous return during periods when the geopolitical risk is high. So we can offset some of the downward volatility of our other assets with our returns on commodities.
“As an example of the substantial impact a relatively small allocation to commodities can give, right now around 50% of PGGM’s first quarter return this year is due to commodities, although our allocation was less than 5%”.

Francisco Carneiro is a member of the board of BPI Pensões, which manages the pension fund of Portugal’s BPI banking group. BPI Pensões has AUM of e2bn
“At the moment we don’t think there is any clear bull market in any financial asset class, and that includes commodities futures. The CRB Index is trading near its 40-week average. All the markets are pretty much range-bound and perhaps because of this some trend-following strategies are not making that much money lately”
“The only two markets where we can see a clear global trend are oil and real estate.The idea that physical assets in general should go up makes sense, because all central banks are printing paper money and we can make a case that you can double the money chasing real goods but you cannot double the physical assets. All things being equal they should go up big time as Jim Rogers says.
“So why haven’t commodities gone through the roof yet? If you double the money available by everybody, we would expect prices to double too, unless people put the money into the bank instead of spending it. If people and corporations think that prices are going up and that they should buy things instead of putting the money in the bank Jim Rogers will be vindicated.
“At BPI we will wait for inflation to pick up first and the ‘put the money in the bank mentality’ to start changing before joining the commodity bandwagon.
“When we make up our minds to plunge in we would probably buy structured products linked to some commodity index to get exposure.
“Currently, we cannot invest directly in the commodity space because of regulatory constraints, but even if we could we would not have the knowledge do it. So we don’t need the rules to change on this.
“The hedge funds avenue is not an option because pension funds in Portugal have a limit of 5% for non-harmonised funds and that limit is pretty much used. We will probably invest trough-structured products when the time is right.
“Some investors think we should put money to work before all the stars are in line because when inflation starts to pick up commodity prices probably will have gone trough the roof. We usually don’t do this because we are not very good at spotting a new bull market before everybody else.”

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