Commodities attract scrutiny
Investors need to ensure they have suitable knowledge of counterparty risk when dealing with commodities, reports Gill Wadsworth
A ttracted by the diversification benefits, European pension funds have pumped billions of euros into the commodities markets in recent years. The €195bn ABP pension fund had 3% (€5.85bn) invested in the asset class as at the end of September 2008, while the French pension reserve fund, Fonds de Reserve pour les Retraites (FRR), allocated €2bn to commodities in August.
Derivatives, usually over-the-counter (OTC) swaps, have often been the route of choice for accessing the commodities markets. As one of the pioneering commodity investors, the €90bn Dutch PGGM fund allocated €2bn through total return swaps eight years ago, while more recently the FRR chose a passive index replication strategy underpinned using swaps.
However, the prevailing economic conditions have brought issues of counterparty risk to the fore, particularly in light of Lehman Brothers' collapse in September, leading to questions about the suitability of derivatives for commodity investment.
"Counterparty risk is at the fore-front of investors' minds and is a much larger part of the decision-making process than it was six months ago," says Eric Kolts, vice president of commodities trading at Standard & Poor's. "If you are going to buy instruments from any bank you have to ask how much faith you have that they are going to be OK."
Consequently, investors are looking at commodity investment products which alleviate some of the responsibility for managing counterparty risk and that are backed by strong collateral protection.
Providers of collective investment vehicles, such as exchange traded commodities (ETCs), believe these products can provide a suitable access. Gold ETCs are widely regarded as transparent, liquid instruments that provide greater security because they use physical securities as collateral. By contrast, with futures or derivatives, investors are at greater risk of counterparty default.
"For something like a gold ETC there is no counterparty risk because the investment is backed by real gold," says William Rhind, head of UK and Ireland at ETF SecuGrities. "Similarly, agriculture ETCs are fully collateralised exposures so they don't have any credit risk. ETCs can provide greater security."
The World Gold Council (WGC) agrees that pension funds have been drawn to gold ETCs because they are 100% backed by the physical asset and do not use derivatives.
Rozanna Wozniak, investment research manager at WGC, says: "Pension funds may be reticent about counterparty risk and some exchange traded commodities are actually based on derivatives rather than physicals."
In November ETF Securities offered 100% collateral to secure the 120 ETCs that track the Dow Jones-AIG commodities index. It claims the move has been "well received" by investors, an argument borne out by strong trading inflows.
APG, which manages the ABP pension fund, combines a mixture of internally managed OTC derivatives with investment in exchange traded vehicles.
ETF Securities believes that fully collateralised ETCs, by virtue of their limited counterparty risk, will be at the forefront of commodity trading during the financial crisis, but the provider remains one of the few players to offer such products.
Despite being a giant in the ETF space, iShares, which is part of Barclays Global Investors, does not yet offer an ETC and Nizam Hamid, head of sales strategy for iShares in Europe, concedes the market is limited for European investors.
"In terms of the smaller and medium-sized institutions, certainly in Europe, I think [commodities] have become a difficult area to access," he says.
Finding a suitable vehicle is not the only consideration for pension funds looking to invest in exchange traded vehicles. Many ETFs employ derivatives within their own funds and often trade with several counterparties. Jelle Beenen, principal for Mercer in the Netherlands who oversaw PGGM's move into commodities, says that investors need to be aware of all the relationships involved in the deal and understand the associated risks.
"The ETFs will have the freedom to use several counterparties so as a client you need to know that the provider takes the necessary measures to manage counterparty and collateral risk, and look at how they handle that operationally," says Beenen. "It is not always transparent how that is done."
ETCs, or ETNs (exchange traded notes) as they are referred to in the US, have proved a popular way for pension schemes to invest in commodities. The California Public Employees' Retirement System (CalPERS), one of the largest in the US, is committed to commodity investment through the use of ETNs, while one of the UK's biggest pension funds, BT, uses commodity futures.
However, the fear of complex instruments like structured products may cause some investors to retreat from ETNs or OTC, particularly in a climate of heightened counterparty risk.
Rhind argues that the ETN market, like OTC swaps, is tainted because of its risk profile and that investors are not willing to trade in structured products or pay the fees associated with them.
Rhind says: "Our principal competitors were investment banks issuing ETNs and structured products that tracked commodities indexes. Those businesses are all declining very rapidly because these are not products that clients want. They are very expensive and the investor carries 100% of the counterparty risk."
Inspite of these concerns, Beenen says Mercer continues to favour structured notes when advising its clients in Europe, but he adds: "We propose a structured note where you know the issuer and where they are a triple-A rated bank."
No matter which vehicle pension funds select to provide commodity exposure, there needs to be a clear focus on risk. Institutional investors must understand every element of their commodity transaction: who is involved; what are the underlying derivatives agreements; what is the level of counterparty risk; and how the is collateral managed.
The multi-billion euro pension schemes will have a greater opportunity to manage their commodities exposure in house, particularly as their sheer scale and influence means they are able to negotiate the best derivatives agreements and fee structures.
However, for the smaller and medium-sized pension funds, greater care needs to be taken finding a vehicle and provider for a commodities mandate that does not leave them vulnerable to unmanaged risk.
IShares' Hamid says: "The world has changed so dramatically in the last 12 months. Where previously investors might have focused on simply getting exposure to a commodity, now there are additional considerations about what risks are they taking on board when trading in any particular product."
Counterparty risk aside, pension funds will still look to commodity investment to provide stability in their portfolios. According to bfinance, during the first half of 2008, ABP and CalPERS both successfully insulated their portfolios against the worst of the equity markets shocks thanks to their commodity investments. The ABP pension fund's commodity allocation returned 44.1% for the first half of 2008 and helped the fund outperform the MSCI All World index by 8.2% over the six months.
The falls in commodity values in the second half of 2008 might mean that the year-end results tell a different story, but pension funds with alternative asset allocations appear to remain committed to their commodity holdings.
And institutional investors' involvement in commodity derivatives may also contribute to reducing volatility in the markets themselves. According to the International Swaps & Derivatives Association (ISDA), pension funds play a vital role in stabilising the commodities markets by "virtue of their willingness to take on the commercial risk confronted by producers in their core activities".
Consequently the industry needs to respond by ensuring investors have suitable knowledge of counterparty risk and provide measures to help manage these exposures. Irrespective of whether a pension fund's exposure to counterparty risk comes through their own total return swaps, or from collective investment vehicles, the focus has to be on protecting against any more nasty shocks in the future.