A bridge over volatile waters
One of the results of the shattering of the old orthodoxies of portfolio allocation in the market collapse at the beginning of the decade has been that pension funds are proving to be more amenable to at least considering alternative asset classes than previously. And this hiatus before new tenets are firmly established is offering a window of opportunity to proponents of commodities, hedge funds, private equity and other novel asset classes that pension fund asset managers would previously have rejected out of hand.
The pitch for commodities is seductive. “We did some analytical research and when we included commodities in our internal asset liability management model we discovered that the long-term correlations of the asset class were really good,” says Michaela Attermeyer, risk manager at Vienna-based VBV Pensionskasse. “The idea is to have a diversified portfolio with asset classes that behave differently. The behaviour of commodities is different from that of equities and although we do not see an inflation risk at the moment it does give a certain protection against inflation, so when inflation rises commodity prices will go up and equities down.”
Jan Willem Baan, chief investment officer of TKP-TPG KPN Pensioen, the pension scheme of Dutch telecoms company KPN, agrees. “Commodities is a nice diversifier in a pension fund’s strategic asset mix in the sense that when you have to cope with long-term obligations in terms of real growth and inflation, commodities work pretty well,” he says. “With most asset categories you need a sizeable chunk before it works in an asset mix, but with commodities it works with quite low percentages.”
“Commodities are very volatile so the amount of risk a 4% commodity allocation implies is roughly equal to the risk of a 30% allocation to fixed income,” says Jelle Beenen, PGGM’s head of commodities and quantitative strategies. “There are two considerations that are widely cited as the advantages of commodities – a positive correlation with inflation and a negative correlation with other assets. But while the link with inflation should help to better match our liabilities, as they are linked to inflation, in fact we found that this effect was limited, because if you want to reduce the inflation sensitivity of the whole fund you have to make a pretty big commodities allocation, so 4% would not help that much. However, a 4% allocation goes a very long way in reducing the overall volatility of the asset mix because of the negative correlation.”
But how does a pension fund get into commodities, what factors they examine before deciding, where do they go for guidance, how do they choose between strategies and indices, does it deliver on expectations and how transparent is the fee structure?
“First there was the strategic question of whether we should get into commodities, and having decided we should, the next question was which index,” recalls Attermeyer. “The process took several years from when we first talked about it because first we found that it was somewhat baffling and second we discovered that there were very few asset managers who were able to help us in our search. Initially we approached Austrian asset managers but saw very rapidly that they could not help us because they were also dependent on international managers. Finally, we were given a lot of information from one asset manager, Goldman Sachs, and we structured a product based on the Goldman Sachs Commodities Index, the GSCI.”
The Bedfordshire County Council pension fund in the UK is in the process of making the same sort of decisions and it is blazing a trail that others may follow. “We have still to finalise an agreement on the investment vehicle in which we would be comfortable investing,” says Geoff Reader, strategic adviser - treasury & pension fund at the Bedfordshire County Council pension fund. “In part, this is because our investment regulations are somewhat constraining but it is also taking time as this investment is quite new for local authority pension funds and we are learning things as we progress.”
But Reader has not lacked advice. “We started looking at commodities about a year ago when we were becoming conscious that we should diversify out of UK equities,” he says. “We were fortunate to start looking at what asset classes to chose from at a time when commodities were starting to come on the UK investors’ agenda. Initially, we started learning about this asset class from one of our investment managers and when we then went to our consultant, Watson Wyatt, to ask what they thought of they asset class they agreed it was interesting for us. So we found that it was quite easy getting information.”
Nevertheless, is not a decision to be rushed. TKP-TPG KPN Pensioen moved into commodities last year. “We had it in mind for some time, but trustees very wisely won’t do something on an impulse,“ says Baan. “We needed to study the situation and then after discussions there was a decision. Of course we were lucky because last year was a nice year to do it, but the difficulty with commodities is that there are also periods with very bad results and you should be prepared to bear them.”
But how much should be invested and in what way? “We decided we would look at putting 5-6% of the overall fund in commodities and then, because it was quite new to us, we were seeking an investment vehicle that would be quite low maintenance; we saw that could be one of the attractions of this new asset class. So we started thinking that a unit trust index achieving approach was preferable. And given that we were looking at a new asset class for us, this also matched a desire not to take too much additional manager risk. Also we had to consider that there are constraints under the local government pension scheme investment regulations under which we operate.”
“We went to the market and asked ‘what can you offer us within a given investment framework?’ The market came back with the two main indices — the Dow Jones and the Goldman Sachs – and the investment panel felt that the DJ/AIG-IC was preferable, as it was more comfortable with the fact that the smaller energy component would make this asset class slightly less volatile.”
But for some the volatility is a key attribute of commodities. “I consider the GSCI and the_DJ/AIG-IC to be market standards,” says Beenen. “They are pretty much the same but the GSCI has a higher energy content because the AIG/DJ-IC has a limit on the maximum weight a particular sector can take, so energy is artificially limited. This makes that index less volatile, but for us commodity volatility is what we like because it provides diversification.
“We have a mix across commodities but we have a very high energy allocation,” he adds. “When we started in 2000 our benchmark was linked to the GSCI, but in early 2002 we changed our benchmark, raising the energy content even more than the GSCI by indexing 75% of our commodities investments to the broad Goldman Sachs index and allocating 25% specifically to the energy-only sub index.”
Others stick to the index. “We don’t under- or overweight on its elements, such as the GS Energy, because our research showed that the GSCI is a really broad and diversified index and we felt that when one is becoming familiar with an asset class and has no experience of it, it was not appropriate to say that we’d start with overweighting or underweighting of certain components,” says Attermeyer.
“We track the Goldman Sachs Index, and while we would have a mandate from the supervisory board to over or under weight, we practice a passive policy,” says Theo Jeurissen, investment officer of Metaal en Techniek (PMT), the Dutch industry-wide pension fund for the metal sector. But the choice to invest in commodities was not motivated by its specialist knowledge of the metals sector. “We didn’t take into account the nature of our industry in making that investment decision,” says Jeurissen. “The companies behind our industry-wide scheme are mostly small and medium sized enterprises that add value by delivering engineering and maintenance services so the materials part in their total turnover is limited.”
And for most pension funds a little commodities goes a long way. “We started our investment in August 2003 with a strategic allocation of 2.5% because it was a new asset class for us and we considered that while it was good to have commodities it should not be too much because of the high volatility,” says Attermeyer, whose VBV is the result of the merger of two other Austrian pension funds, BVP and PVK. “As a result we have approximately 40 different portfolios, and currently only those that were formerly part of BVP are invested in commodities. So, since the merger we are underweighted commodities and we are always looking for the right moment to become neutral weighted. Our strategic allocation should remain 2.5% but our internal structure means that another team will decide when would be the right time tactically to make the allocation.”
“We don’t do any tactical allocation within asset classes,” says Vera Kupper Staub, CIO of Pensionskasse der Stadt Zürich. “So, we don’t have a tactical view on commodities and so if we do not make any strategic changes will always stay with 2.5%. Although the volatility of commodities is huge – in most of the years that we have invested in commodities they were either the top or bottom performing asset class – they have a volatility-reducing impact on the total fund’s return volatility. This is the positive impact of its correlation characteristics. However, this positive impact vanishes when the share of commodities becomes too big.”
But this has not been Beenen’s experience. “We started to invest in commodities long before a lot of institutional money started to flow into the asset class, with 4% of our portfolio,” he says. “It has increased marginally, a decision to have it a little higher in the strategic mix was implemented this year and we are now approaching 5%. We found that a 4-5% allocation to commodities already substantially reduced the overall volatility of PGGM’s total asset mix. Typically those times are either when economies are overheating or at a time of geopolitical risk.”
PMT has also been in commodities for a number of years. “We decided on broadening our asset mix in the direction of alternatives, which in our case meant commodities, private equity and hedge funds,” recalls Jeurissen. “This was based on a strategic policy decision at the turn of the century which was implemented step-by-step and we are still increasing those investments. The decision was based on an asset liability study showing that we could diversify, and thereby reduce the risk at the fund level, by going with these asset classes. We have 3.5% in commodities, and this is a stable exposure.”
But does it deliver? “Commodities have behaved as we expected in a diversified portfolio,” says Jeurissen. “Given an extra dimension of diversification we have seen tremendous returns on commodities in years with negative returns on equities. So it has really helped to stabilise our returns and that is the basic idea.”
“During overheating commodities prices are supported by a high demand to keep the industrial processes going, but at that time equity markets are already realising that prices are at the top and the only direction is down,” says Beenen. “Geopolitical risk, such as the trouble in the Middle East and the Iraq war, are not in general helpful to most assets. However, energy futures have had a tremendous return during periods when the geopolitical risk is high, so we can offset some of the downward volatility of our other assets with our returns on commodities. Around 50% of PGGM’s first quarter return this year is due to commodities, although our allocation was less than 5%,” he adds.
But is it feasible to make a major allocation and to invest in commodities as an asset class specifically to give a return and not just as a diversifier? André Ludin, head of portfolio, currency & risk management at Basel-based Novartis International AG pension fund thinks so. Novartis has around one third of its invested portfolio in commodities. “We decided to invest in commodities in two ways: first directly in large mining companies and second to invest in commodity-index-ETFs,” says Ludin. “We have shares in five or six large global companies – Rio Tinto, Broken Hill, Vale Do Rio Doce, Xstrata and maybe Phelps Dodge – and these account for 7-8% of our invested equity portfolio, which is around 40% of our total portfolio. We chose metals because high-grade ore reserves are being exhausted, which means that in the longer term metal prices must increase. And this is a general problem with all major metals.
“Currently, we have an ETF in the GSCI, and within a few months we will have another in the DJ/AIG-IC. ETFs on metals, energy and agriculture are in preparation. We are waiting for prices to drop, it is a long-term investment we are not under pressure to invest under all conditions, but our target is to invest close to 10% of our portfolio this way. On top of that we have 5% in gold mines and 20% in oil companies. In 2003 we increased our oil portfolio, and although at the time we were wrong, the following year it turned out to have been an excellent investment.”
But what about fees? “I think commodities are relatively expensive in their management,” says Baan. “It is known in the industry and should be known by anybody wanting commodities in their asset mix. But of course there are other forms of investment that are even more expensive, such as private equity or hedge funds to name but two.”
However, Beenen says the situation is improving as the market develops. “When we started in 2000 we found only four counterparties prepared to do total return swaps on the GSCI with us,” he says. “The situation now is significantly different. A lot of parties that went out of commodities after the 1998 oil price moves are desperate to get back in and some of them have only the fee to compete on because they have difficulty to distinguish themselves as commodity experts. So that has pushed fee prices lower.”
And he sees the reasons for the charges. “Many, including investment consultants, put too much emphasis on the cost of commodities, saying it is an expensive asset class. At first sight fees of around 50bps a year look very high compared with index investments in equities or fixed income. But it’s not just pure profit for the swap counterparty. If they hedge that index in the futures market they have to roll the futures every month. And if you assume, and this is cheap, 1bps each go, to sell and buy a future means 2bps for every roll, and if you do that 12 times that’s already 25bps. Moreover, they guarantee the close, so the inter-day slippage is a risk for the counterparty. Arguably they make money out of it, but it’s still a risk for them. For me the consideration is whether replicating the index ourselves is an optimal use of my resources. We could do it ourselves, and actually for about 5% of our total commodity exposure – so 5% of the 5% – we do roll futures ourselves and replicate the index. But that’s more to keep in touch with what’s happening in the market. I would rather have my people spend their time on smarter things where we have an edge and can make a greater amount of money. For us total returns swaps are an easy and convenient way to get a zero tracking error replication of the index and on balance we accept the costs involved.”
And there appears to be little dissatisfaction elsewhere at the level of fees. “As far as we can judge the fee structure on our product is really transparent,” says Attermeyer. “We know the management fee of our product.”
“The fee structure of an index is cheaper than when one makes one’s own portfolio with a bank,” says Ludin.
And fees are also not a deterrent for the neophytes at the Bedfordshire County Council pension fund. “Because we were thinking unit trust and we were expecting a normal fee structure and that is what the market seemed to indicate was its preferred route, so ad valorem” says Reader.