Commodities take their turn
With commodity prices on the rise, interest in investment is perking up after a quiet period lasting since the 1980s. Pension fund managers are being reminded that investing in commodities can play a unique role in a fund’s portfolio.
Current market conditions are ringing alarm bells, as market activity is high, with the world economy in an expansionary mode, and inflation, although low, is rising. This is just the environment in which bonds and equities underperform. Coupled with the fact that commodity prices fell to all-time lows last year and have yet to complete their recovery, commodities investment looks particularly appealing.
Because of current economic conditions, the Goldman Sachs portfolio asset allocation has gone overweight in commodities, moving up to 8%, from 5%. Goldman forecasts commodity returns of 18% for 2000, against 6.8% for equities, 5% for cash and 3.9% for bonds.
While it is possible to make short-term gains on commodities dealing, the best bargains may already have gone. “Pension funds all wake up far too late – their timing is usually pretty bad,” says David Duncan at Global Asset Management in London. “This is particularly poignant with commodities, because it is a volatile market.”
“At the end of 1998 and into the beginning of 1999, prices of energy, grains and base metals were all at historic lows, the situation was very extreme,” says Boris Shrayer, vice president, commodities, at Morgan Stanley Dean Witter. “Buying at that time presented unique opportunities,” as returns rose around 50% during 1999, coming close to their five-year average. However, he points out that they are still down 40% from their highs two and a half years ago: “There is certainly room to grow.”
Catherine Claydon, head of marketing for the Goldman Sachs Commodity Index in London, expands on this idea. At the same time as we are seeing a rebound in global growth and therefore increased demand for commodities, commodity inventories in several sectors are close to being critically low, because there was a lack of new investment when prices were low. “With commodities, there is a significant time lag between increased demand and increased production, so prices often need to rise to bring demand down back in line with supply. This points to the possibility of temporary price spikes or even longer price rises in 2000,” she says. However, looking for opportunistic gains is not playing to their strength – the real benefits of commodities are not in the opportunities presented by shorter-term investment. So while investing now may be a smart move, it also has positive long-term benefits for overall portfolio strength.
More important than short-term profitability is the fact that commodities can perform as a key diversifier in portfolios. Their essential strength in terms of asset allocation is that they are negatively correlated to stocks and bonds. In fact, as Claydon points out: “Commodities represent the only asset class that is truly counter-cyclical, that is always negatively correlated in the long run and not just non-correlated. This makes them a useful macroeconomic hedge when economic conditions are above trend.” In general, commodities perform better when inflation is rising, and when the economy is stronger – this is the opposite reaction to bonds and equities.
Institutional investors generally hold commodities in the form of futures contracts, and the return is generated by the regular trade in contracts. The return on commodity investment comes from backwardation: when the spot price at which the commodity futures contract is sold is higher than the price for the futures contract bought. The returns from commodities are not great, generally lower than stocks and after inflation closer to bonds. “If you are looking at the long term, returns are positive, but they are not internet stocks,” says Shrayer. However, they are certainly stronger than cash. As Goldman’s Claydon points out, a passive, long-only allocation to commodities has historically generated long-run returns 400–500 basis points over cash. Duncan at GAM recommends that pension funds interested in the role that commodities can play in their portfolios take a close look at their trust deeds. “A lot of funds may discover that they are not allowed to invest in commodities or commodities funds. They may be judged too high on the risk scale. Some trust deeds either forbid this investment, or define permitted investments too narrowly.”
In addition, it may not be clear how commodities are regarded in terms of the minimum funding requirement. Often commodities do not fit the categories, so if a fund is not strongly funded, then commodities investment will not be possible.
Few pension funds have chosen to devote a significant proportion of their asset allocation to commodities, although interest is definitely on the rise. A few large pension funds in North America, and some of the top Dutch and Swiss funds, have made moves, but there has been less interest in the UK. Those funds that are permitted to go ahead with commodities investment have their choice of routes into the market.
It is possible to go in directly. Investment in a particular commodity, through a structured note or a swap, is a possibility, albeit a risky one: the level of research required to construct a successful strategy based on direct investment is akin to investing directly in equities. There is a market in Chicago for listed futures contracts, with $2.25bn in open interest; it is also possible to enter into over-the-counter agreements in swaps and securities linked to the index.
The most common route is to invest in an index basket following the GSCI or another benchmark, using a third party asset manager. In fact, there is a GSCI futures contract traded on the Chicago Mercantile Exchange.
A more opportunistic approach is to follow a particular trading strategy. For example, Morgan Stanley has devised a set of trading strategies directed towards an “optimal index” based on the idea that different categories of commodities respond best to different approaches to trading. MS defined six strategies and applied them to 29 futures markets, evaluating the performance of each market on its own and in combination with other markets. This way, based on Morgan Stanley’s research and analysis, investors can enter into swaps based on a choice of the most suitable trading strategy for each category of commodity, with the aim of bettering performance.
Funds also invest in commodity-linked equities, such as the shares of mining companies or other natural resources firms. The strength of this form of investment, according to Graham Birch, in charge of the natural resources team at Mercury Asset Management in London, is that “a successful company has the potential to grow, and then the shares are worth more. This is not something that a ton of copper can do”.
In his view, commodity-linked equity investment offers a leveraged play on the underlying commodity. “You can get the same leverage by investing in a call option – but call options expire. With funds like ours, you can leverage to a rising price but with a never-ending date.” He offers the example of a gold mining company, which produces gold at a cost of $200/oz. When gold is at $280/oz, this means an $80 profit that is passed to shareholders. If the gold price rises to $380/oz, the profit margin of the mining company increases by a greater proportion to investment than it does with direct investment in gold.
However, the diversification benefits are much less clear cut with this type of commodity-related investment. These stocks do benefit when conditions favour the underlying commodity. Mark Latham at Barings stresses that natural resources stocks “perform extremely well when activity is accelerating, as it is now. And we encourage institutional investors to be of the view that activity is as important a factor as inflation these days.” Barings’ global resources fund, with around $100m under management, has ranked second in its asset class since its inception five years ago.
However, others warn that, no matter what they are invested in, equities are equities. More often than not they will follow the market rather than the commodity being produced. In addition, says Shrayer at Morgan Stanley, many commodity producers are highly leveraged, and last year many closed down.
However, as Birch points out, “You don’t have to follow one strategy or the other. If you are looking for commodities exposure, why not have both direct and indirect investment? For an investor who is bullish, it makes sense to invest in equities to get that extra oomph.”
A number of funds also have commodity components. For example, GAM offers a multi-manager hedge and trading funds, which have commodities as one part of it. Duncan says that this fund “offers a very broad-based alternative investment structure”, using non-correlated hedge, currency and commodity strategies.