Commodities have always been considered a highly risky investment not suitable for conservative portfolios. The scarcity of suitable ways of investing in them has also hindered their inclusion in mainstream portfolios. However, the steady rise in prices of commodities, particularly industrial metals and oil, and the flat performance of equities and bonds, means that commodity index products are being taken more seriously.
Commodity investment can be used to reduce risk. The asset class offers many of the characteristics investors require when equities and bonds are struggling to provide them. Individual commodities can be volatile, but because of their low correlation with equities and bonds a properly structured and diversified portfolio will lower overall volatility. Currently, with improvements apparent in the global economy, demand for commodities is rising steadily, presenting a good case for institutions to harness this growth as part of asset allocation.
Just as important at a time of threatened rising inflation commodities provide an effective hedge. Commodities tend to respond directly to changes in the economy that are apt to produce inflation. For example, an increase in demand for finished goods and services that prompts consumer price increases is likelyto be accompanied by rising demand for commodity inputs, such as energy or metals.
A weak US dollar and continued strong metals demand from China also offer price support. Commodities are quoted in dollars. Prices of commodities have to rise when the dollar weakens to counter the effect on revenues.
The China and India stories are the most compelling when it comes to demand. China needs to purchase raw materials to feed global demand for low-cost products and to expand manufacturing capacity, which drives up the cost of industrial metals and oil. Kerr Neilson of fund manager Platinum International says: “If China and India come close to traditional patterns of materials use it is probable that we are entering a secular rise in the price of many materials and metals. Already China accounts for a fifth of world consumption of important metals such as steel, copper, aluminium and zinc.”
According to AIG, which operates the Dow Jones AIG Commodities Index (DJ-AIG-CI), the historical risk premium of commodities is comparable to that of equities and exceeds that of bonds. In addition, commodity returns have historically demonstrated little correlation with returns from either equities or nominal bonds. This is largely because rising inflation erodes the value of fixed-income investments and is typically not favourable for equities. This negative correlation is stronger over longer periods.
Investors in commodities do not usually buy the physical commodities, although a few funds do hold them. Nor are investors likely to get the required performance from buying a portfolio of listed commodity-related companies. Shares of commodity companies are considered a poor substitute for investment using commodity futures, as there is only moderate correlation between commodity-based equities and underlying commodity prices.
According to AIG’s research, despite individual commodity futures being volatile, as constituents of an index the volatility is lower than that of most equity indices. AIG further argues that the perception of commodities as being extremely volatile is not correct. Commodity futures perform better in periods of inflation, especially unexpected inflation, when equity and bond returns generally disappoint. The reality is that the volatility of individual commodity prices is comparable to and often less than that of individual equities. Many investors confuse the potential leverage of futures trading with the volatility of commodity prices.
Typically, a commodities portfolio will track one of the main indices, either the Goldman Sachs Commodities Index (GSCI) or the DJ-AIG-CI. The GSCI is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures. Individual components qualify for inclusion in the GSCI on the basis of liquidity and are weighted by their respective world production quantities. The DJ-AIGCI is composed of futures contracts on 20 physical commodities traded on US exchanges, with the exception of aluminium, nickel and zinc which trade on the London Metal Exchange.
In Germany, Frankfurt investment consultancy SaxHolbein has developed a commodity index product. SaxHolbein director Ellen Sullivan says: “We are using a structured note based on the Dow Jones-AIG commodity index. A passive product, as opposed to actively managed commodity-based investments, allows the investor to participate in market movements in a cost-efficient basis. This product is an inflation hedge, and would immediately respond to an increase in inflation.
“The timeliness of commodities is certainly relevant, and this has been a neglected asset class in the past decades, but I personally feel the asset-allocation and diversification aspect is just as important.”
The combination of commodities in a structured product enables the investor to track the performance of physical commodities, where actively managed funds are mainly invested in commodity-related companies. Performance is therefore, a purer reflection of the commodity markets. Using a structured product, it is also possible to benefit from backwardation – the differential between today’s price and the forward price of a given commodity. Such opportunities are commonplace when demand is high and, in such circumstances, the fund manager might be able to pass on more than 100% of the rise in the price of each commodity.
PGGM, the E53bn Dutch pension fund, has been investing in commodities since 2000 and has 4% of its assets invested in them. In total, PGGM invests in 26 different commodities in the energy, industrial metals, precious metals, livestock and agriculture sectors. By investing in commodities, PGGM limits its inflation risks. According to portfolio manager Jelle Beeven: “The reason we started investing in commodities is that internal ALM studies indicated very low, even negative, correlations with other asset classes and a positive correlation with inflation. The negative correlations with other assets make the total portfolio much more diversified. The positive correlation with inflation is an added bonus, because PGGM’s liabilities are linked to inflation.”
The consensus is that metals and oil prices will remain strong for the foreseeable future. PIMCO’s investment team believes that commodities are on a long-term positive run. They conclude that production has suffered from under-investment, and that it will take higher commodity prices to attract this.
Dan Peirce, portfolio manager at SSGA, suggest there is still great scope for investors in commodities. “The positive fundamentals are getting attention from investors worldwide and the increasing need for diversification and new sources of return make commodities an appealing alternative,” he says. “We believe an inherent scepticism regarding the valuation of commodities should not keep investors away from the significant potential that commodities represent.
“Two concepts suggest that, despite recent strong performance, commodities still have ample potential. First, the value of commodity production relative to global GDP has fallen since US inflation peaked in 1980, implying that commodities are cheap in terms of economic contribution.
“The second concept is the value of commodity instruments relative to financial instruments. This has also declined, making a substantial reallocation of capital from paper assets to hard assets much more plausible than the reverse. The two largest sectors in the S&P500 are financials and information technology, with a combined weight of nearly 38%. The energy and materials sectors together comprise barely 9%. If commodities are already too popular, equity valuations are not showing it. Direct investment in hard assets through commodity futures is only beginning to gain traction, while two decades of robust stock and bond returns still have many investors relying hopefully - perhaps too complacently - on long-term equity ownership.”