Central banks are doing it. Pension and sovereign wealth funds are doing it and now even wealthy families are doing it. Institutions in Asia are increasingly turning to commodities such as gold, metals and even coffee and wine for attractive returns and to better hedge their investments against inflation and other market risks.

 The development of commodity futures indexes and financial instruments that track such indices also aided growth of this asset class. Still, before investors add commodities to their portfolio or further adjust their allocations, they do need to know some fundamentals of these real assets.

G.S. Khoo, a North American global investment fund manager says it is important to understand whether the commodities themselves - the produce, the equities of commodity companies or assets such as agricultural land, mines and oil wells - behave like a mainstream asset class that can be part of the risk-return spectrum with a long investment horizon (low-risk, low-return, high risk-high return) or are they more like FX, which mean-reverts but fluctuates on a short-term basis.

Khoo adds the equities of commodity companies or the real assets (agricultural-land or mines) probably satisfy this “rule”, based on the efficient frontier behaviour. “Since pension funds are long-term investors, I believe the expected longer-term performance of these asset classes will yield a higher risk-adjusted return if the asset selection (stock selection), timing and exit are appropriate.”

Multi-decade growth
Accelerating economic growth in emerging and developing economies has been a major force behind the commodity price boom. Urbanisation and the rise in demand for housing and infrastructure in these economies increased their reliance on commodities. Going forward, the world will see multi-decade growth in demand for minerals, metals and commodities, especially led by China, India and the rest of developing Asia, says Owen Hegarty, Vice Chairman of Hong Kong-listed G-Resources, which runs the Martabe gold mine in Indonesia and has plans to be a regional gold mine operator. “Yes there will be humps and bumps and pauses along the way, but the direction and force are clear.”

China has passed the point of “economic take-off” to sustained economic growth in textbook terms and is in a minerals and metals intensive stage of growth, which means it will continue to invest heavily in infrastructure, Hegarty adds. The country is also experiencing the largest urban migration the world has ever seen and its leadership has a social and political imperative to see standards of living continue to improve. “Similar patterns will occur in the rest of the developing world - all long term positive for commodities and the resources industry.

“Supply will be running to catch up - and it’s where we are seeing and will continue to see some constraints such as access to exploration and development capital, availability of delivery infrastructure, resource nationalism and falling discovery rates for some minerals.”

Along the way, as supply rushes to catch up with demand, there will be structural adjustments and price volatility for some commodity products. Hegarty adds: “So yes, institutions and central banks will increasingly turn to commodities for greater security and returns.”

The ‘perfect metal’
With rounds of quantitative easing and extended low rates, gold and other precious metals have been in the spotlight in recent years and abundant liquidity are favorable to the long-term performance of the metals. For Hegarty, gold is the “perfect metal”. That also appears to be so for central banks globally. The net sellers of the precious metal are now net buyers. Largely driven by the need to diversify their reserves, central banks in Asia and other emerging markets have continued to purchase gold and official demand for the precious metal will likely remain strong, according to the World Gold Council.

South Korea, Thailand and Sri Lanka are some of the countries that have increased their gold reserves in recent years and will likely continue to do so, says Albert Cheng, the Council’s Managing Director - Far East. “It is largely driven by the need to diversify their reserves, and gold is a tangible asset they can diversify into.”

Central banks globally have continued to purchase gold in Q3 2012, abeit at a slower pace from year ago level, with demand at 97.6 tonnes, worth about $5.2bn. The purchases accounted for 9% of overall demand in the quarter. The Council estimates that “purchases of the similar order of magnitude” are expected in the fourth quarter. Moreover, the factors that have driven gold prices and purchases to record high levels haven’t abated and the ongoing quantitative easing by the US Fed and the Eurozone crisis will continue to drive investor demand, Cheng says.

G-Resources’ Hegarty adds: “It is a commodity, a currency, a store of value, a safe haven and a hedge against inflation and world financial and political uncertainty. All of the reasons to own gold are in positive territory.

“Equally, investors - institutional, corporate and private - and hoarders are seeing gold in a brighter light.”

Global gold demand in the Q3 2012 was 1,084.6 tonnes, down 11% from the record figure of 1,223.5 tonnes in Q3 2011. Gold demand remains resilient as the figure in the third quarter was above the five year quarterly average of 984.7 tonnes, according to the Council. The Indian market is showing signs of recovery, following increases in both jewellery and investment demand. With signs of the Chinese economy bottoming out, demand in China for gold is also likely to rebound in the coming quarters, Cheng says. “The title of world’s top gold consumer will switch between China and India for some time to come.”

Even though gold has outperformed almost every asset class in the past 10-15 years, the capacity to supply new gold remains under pressure, Hegarty adds. Discovery rates of significant deposits have fallen while new gold mining projects take longer, cost more and have lower ore grades than ever before. So what will the price of gold do? “It will behave like any other commodity where demand is strong and the supply response is subdued; it will be volatile, it will fluctuate, it will be very popular and it will trend north-easterly!”

Other commodities
Aside from gold, demand for silver and other precious metals such as platinum and palladium are also rising, but they trade in a smaller market. Other favoured commodities – copper, iron ore, coal, crude oil, coking coal and aluminum - are also closely tied to growing emerging markets demand, especially China and India.

Singapore’s investment company Temasek Holdings has said it continues to see opportunities in Asia, and believes that China and India will account for more than 50% of global middle income consumption by 2050. This in turn will drive demand for commodities, energy and resources; for consumer goods and services, including technology and biotechnology products; and for services as middle income population needs grow. Temasek, in the fiscal year ended 31 March 2012, doubled investments in energy and resources to 6% and is expected to continue to invest in these sectors.

Unlike traditional stocks and bonds, commodities tend to react to changing economic fundamentals such as inflation and demand/supply patterns that affect consumption. For those who may not have the stamina to withstand the full exposure to commodities, equities may be where the real leverage is, Hegarty says. “Investing in companies with significant exposure to your favourite commodities can provide serious upside and significant returns.”

But this also clearly carries risks beyond investing in just the commodity. “With a company you are investing in one or more commodities, possibly various stages of development from exploration to production, different scale of exposure, variable quality of the underlying orebodies and assets generally and, probably most importantly, variable capability of Board and Management.”

One option of gaining exposure to commodities while managing the risk is through investment instruments such as commodity exchange-traded products. The instruments that track commodity futures indices, such as the Dow Jones-AIG Commodity Index and the Dow Jones-UBS Commodity Index, are composed of futures contracts on physical commodities and are not the same as actively-managed futures accounts. They cover a broad range of commodities and any changes made to the composition of the indexes are also determined by a number of preset rules rather than just based on an asset manager’s decision.

Country exposure
The boom in commodities demand and prices is certainly benefitting supplier countries, including Australia and Brazil, as well as leading to more and more exploration and development for minerals in resource-rich countries.

China, for example, is Australia’s biggest trading partner and about 60% of Australian exports to the country comprise raw materials such as iron ore and coal. Investors seeking exposure to China and rising commodity demand and prices have been investing in Australian government and corporate debt, equity as well as currency. As much as 80% of Australia’s government bonds are already owned by foreign investors, says National Australia Bank’s Group Chief Economist Alan Oster. “Australia is a real triple A economy and people see it as highly correlated to China.”

China’s growth has thus been increasingly important to the Australian economy. For Australia, it has seen higher levels of investment into mining and energy projects and companies, with benefits trickling down to engineers, contractors and even retailers and banks. “The Australian economy is incredibly multi-speed. You’ve got policy doing different things. You’ve got fiscal policy being tightened and monetary policy being eased.”

Australia is also undergoing different set of phases in its mining boom. In the three phases of the mining boom – big in increase in prices; big investment in mines; and less investment in mines but big increases in exports – Australia is currently in the “peak of the second phase”, Oster adds. These mining projects are largely funded for exports to Asia. “China is very important for Asia, it’s very important for us and it’s also important for the world.”

Even though China’s economic growth has slowed, Oster holds the view that China is going to engineer a soft landing. If investors fundamentally believe in the Chinese growth story, then basically Australia is like a substitute for China. “I can put the question a different way, would you prefer to be exposed to Europe?”

G-Resources’ Hegarty adds: “There is no doubt Asia is going to continue to dominate consumption growth of commodities. The trend for the last 10 to 15 years will continue and indeed potentially accelerate as growth accelerates in India, Indonesia and other countries in developing Asia.”