Since the global equities markets peaked in the 1990s, disillusioned institutional investors have looked to diversify their portfolios by investing in a wider range of asset classes. Investor interest in commodities lay dormant as institutions made allocations to the booming equities market but the current appetite for alternative sources of returns has led to a renewed interest in commodities.
“Institutional investors are increasingly thinking about investing in commodities, partly because they offer diversification benefits, which is a good reason, and partly because they have been in the news and have performed well, which is not such a good reason,” says Robert Brown, senior investment consultant at Watson Wyatt.
According to Evy Hambro, a manager of the Merrill Lynch World Mining Investment Trust, which operates a global portfolio of mining and metal securities with up to 10% of the assets invested in physical metals, commodities fulfil a range of different roles in a portfolio, including diversification. “When it comes to the portfolio context, commodities are considered part of the return-seeking component,” Brown says. “Historically, the return figures look similar to equities and over the long term, a timeframe of 30 years or so, they have a slightly negative correlation although this can be quite variable over shorter time periods.”
This distinct return profile allows investors to reduce the inherent risk of the portfolio and balance its performance as equities go up and down. But, according to Katharine Pulvermacher, head of asset allocation research at the World Gold Council, different commodities behave quite differently and investors should look at the drivers behind each commodity before investing in it.
David Blitzer, managing director and chairman of the index committee at Standard & Poor’s, has also noticed a good deal of renewed interest in commodities, both in the US and in Europe. “This is partly to do with rising concern about inflation now that the US Federal Reserve, the European Central Bank and the Bank of England are all looking closely at interest rates,” he comments.
Historically, commodities have tended to provide good performance in times of high inflation. They can, therefore, act as a useful hedge during volatile times. In the past, natural resources such as oil, gas, precious metals and agricultural products, have proved to be a good long-term investment, with the Goldman Sachs Commodities Index (GSCI), for example, returning an average of 11.6% per year from 1970 to 2002. But this is a volatile asset class and investors would be wise not to overweight their portfolios, treating them as they would any other alternative asset class.
Pulvermacher recommends that before investing in commodities it is advisable to look at the relationship between each commodity and economic growth, particularly in those parts of the world where the growth rate is high. She cites lead as an example of the complex nature of the asset class. “China is a large importer of lead, which it uses predominantly to manufacture batteries,” he notes. “But most of these batteries are exported abroad so a complex range of factors comes into play when analysing the potential risk-return profile of this commodity.”
Institutions interested in making allocations to commodities may find the complexity of these investments poses a challenge. “Although investors are increasingly turning to the asset class, few investors really know how to go about investing in commodities such as oil,” Brown comments. “It is therefore very common for them to buy into the asset class via an index.” When it comes to implementation, deciding which benchmark to use is key and Brown has a preference for using an enhanced index approach as this is likely to generate returns closer to the total return index.
Diversified indices, such as the Dow Jones AIG Commodities Index (DJ/AIG-CI), the GSCI, the Reuters/Jefferies Commodity Research Bureau Index and the S&P Commodities Index (SPCI) allow investors to access the liquidity of the underlying commodity markets and offer price transparency but vary greatly in their composition. The DJ/AIG-CI is composed of futures contracts on 19 physical commodities, while the GSCI currently contains 24 commodities from all commodity sectors: six energy products, five industrial metals, eight agricultural products, three livestock products and two precious metals. Meanwhile, the SPCI, which was launched in October 2001, tracks 17 commodities in six sectors.
Brown feels that it is important to manage return expectations. “In a collateralised commodities futures programme, the cash returns are likely to be low,” he explains. Commodities tend to have a positive skew and are a useful hedge in times of geopolitical crisis and depressed equities markets. But return premiums have declined gradually and have been quite variable.”
Brown therefore advises adopting a diversified approach to the asset class and, if timing is not an issue, using a phased investment strategy.
Brown sees a distinction between what he refers to as “true commodities” such as oil and cotton, which obey the fundamental laws of supply and demand, and precious metals, which follow their own cycle. Hambro feels that, when it comes to constructing a portfolio, investors who only own precious metals have a one-dimensional exposure to the asset class as they are only exposed to the inherent metal class price. “But if you invest in equities, the inherent exposure to the commodity price and the equity risk, if managed well, can be used to extrapolate greater rates of exposure,” he adds.
The ultimate diversifier is gold as it does not correlate with anything else. “Gold is unique because it has all the diversification benefits of other commodities but also plays an important monetary role,” Pulvermacher says. “It comes into its own in times of unrest when its protective insurance quality appeals to investors.” According to Blitzer, gold tends to follow its own rulebook, and investment is driven by emotion, psychology and political rumours.
Blitzer advises investors to be cautious about investing directly in oil or in an index with a huge weighting in oil. “Although there is money to be made in oil, you have to be skilful in order to be able to take advantage of the current price increases,” he says. “The recent behaviour of prices and futures contracts is very unusual and could be potentially treacherous.”
Pulvermacher also has a word of caution for investors: “Just as different sectors perform differently at various times, so different commodities display different strengths at various points in the economic cycle.” Brown feels that institutional investors should be open-minded about investing in the asset class while making sure that they implement any investment carefully.
But despite this renewed interest in commodities, only a handful of UK pension funds are currently investing in the asset class. Investing in commodities does not appear to be high on the list of priorities for pension funds, particularly now that that they have so many other issues that are stretching their governance budgets. But Brown feels that as pensions funds continue to appraise different asset classes, it is only a matter of time before they start to seriously consider investing in commodities.
According to Pulvermacher: “We are beginning to see a wave of interest in commodities, particularly from consultants, who are taking research and exploration into the asset class very seriously.” But she does not expect investment in the asset class to increase overnight. She adds: “Investing in this sector is very much on the institutional agenda but the decision-making process is moving very slowly. The first building block is research and it is clear that the level of debate is moving on. It is healthier if the move into commodities happens gradually as we are less likely to see a bubble develop.”