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The pension fund of the Canton of Zurich (BVK) has been investing in commodities since August 2006 when it decided to  allocate 4% of its portfolio to commodities.

Its strategic exposure consists of seven individual commodity investments in three sub-categories. At end-June 2008 a collateralised commodity index note accounted for 39% of the commodity portfolio, a fund of commodity funds for 34% and enhanced index funds for 27%. All investments are hedged in Swiss francs.

The commodity index note is designed to replicate the Dow Jones AIG Total Return index through a commodity excess return swap and a collateral investment.

"The collateral is safely invested in a money market fund, which reduces the credit risk substantially," says Daniel Gloor, head of asset management at BVK. "AIG, as the issuer of the index note, does not have access to the collateral. The implementation of the note is optimised with regard to counterparty risk, currency hedging, time of roll and tracking error. And so the counterparty risk only involves the commodity swap with AIG."

Although, like the majority of pension funds, BVK has suffered from plunging share prices amid the market downturn, Gloor says that the pension fund has not incurred any capital losses because of counterparty risk on its investments.

"That is why we will maintain our current commodities strategy, including the deployment of swaps and futures," he adds. "However, we intend to look for alternative index providers due to the now higher operational risks at AIG. In terms of collateral, we exclusively consider highly rated money market funds."

BVK is not interested in investing in commodities through exchange-traded funds (ETFs) or exchange-traded commodities (ETCs), says Gloor.

"Commodity ETFs would not be able to fulfil the needs of the BVK," he notes. "We would not have any influence on the index - which is usually the S&P GSCI or Rogers index - its replication, the collateral, the time of roll and the tracking error. On top of that, costs would be two-to-three times higher with an ETF than with our current bespoke index solution."

Before it added commodity hedge funds in June 2007, BVK's commodity exposure was purely long-only. With its adviser, DL Investment Partners, BVK decided to protect the commodities portfolio against a market downturn and to reduce
volatility by adding commodity funds of funds. But while, compared with a pure long-only portfolio this led to underperformance in 2007 and the first half of 2008, it turned out to have been a wise decision when commodities markets subsequently crashed, resulting in an outperformance of +9% versus the benchmark until the end of October 2008.

"We will keep the structure of our commodity portfolio - around two thirds long-only and one third long/short - for now, because we do not expect a significant recovery in the commodity markets over the coming months," Gloor says.

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