Bringing commodities into the frame
It used to be much ignored asset class, but commodities have been back in favour for the last several years, producing double-digit returns at a time when the equity markets were underperforming. It is no surprise then, to see that institutional interest in the asset class has increased.
“Commodities have a much lower correlation to other asset classes in terms of diversification,” explains Mark Hooker, director of State Street Global Advisors’ Advanced Research Centre. “And importantly, you get diversification in times when its really important, so the probability that commodities will have a positive return in the year that equities have a negative return is pretty good.”
The diversification argument has sold commodities to many pension schemes, some of which have allocated up to 5% into the asset class. Others have adopted more sophisticated strategies. ABP, Europe’s largest pension fund, uses commodities as a hedge against inflation and event risk. It started investing in 2001, with a 2.5% or €4.5bn in assets allocation. Another major Dutch fund, PGGM, manages commodities in-house because it wanted to focus on the characteristics of the asset class rather than outperforming benchmarks.
Commodities also have a much more favourable correlation with liabilities, points out Hooker. At a time when pension funds are focusing on liability matching, it is an attractive offering.
Typically, institutional investors focus on commodity futures on an index because the prospect of taking physical delivery of something like wheat or oil is problematic. A commodities futures index measures the returns that an investor would generate from long positions on futures contracts, and rolling these positions forward over time, selling them as the delivery date approaches. Funds invest passively or benchmark against the Goldman Sachs Commodities Index (GSCI) or the Dow Jones AIG Commodities Index (DJ/AIG-CI). The GSCI is a composite index of commodity sector returns, returns are calculated on a fully collateralised basis, with full reinvestment.
Hedge funds have also made inroads into the asset class, outside traditional CTA or managed futures strategies. Jim Rogers, former star fund manager of George Soros’ Quantum Group, set up a new fund through Diapason Commodities Management, the business he formed with Equinoxe Partners in 2003, and predicted a long bull market. Hedge funds are active in both long and short investments, and have been cited as the cause of market movements.
“Hedge funds have been active in 2004, but less active than the politicians are saying,” explains Philipp Vorndran, managing director at Credit Suisse Asset Management. “Some politicians have made hedge fund managers responsible for the market spike we’ve had in the last 24 months. I don’t think that’s the case.”
Hedge funds aside, it is easy to see why long-only investors are also attracted to the asset class. In the five years to December 2004, the GSCI produced average returns of 15% compared with 8% on bonds and -1% on stocks, according to research from Barclays Capital.
Dutch schemes have been at the forefront of commodity investment, and many observers believe that the new FTK assessment standards in the Netherlands, which values both assets and liabilities on a marked-to-market basis, will propel commodities even further into the spotlight as portfolio diversification becomes paramount.
But managers insist they are receiving interest from funds across Europe, not just Dutch investors. “I think there will be a broadening of investors,” says Hooker.
Still, mid- to small-size funds have traditionally been wary of volatility from commodities. While hedge funds are able to shift in and out of a position rapidly and take advantage of short term plays, pension funds have less flexibility. The volatility of the GSCI over the five years to December 2004 was 22%, compared with 15% from stocks and 5% from bonds. “Investors are concerned about where we are in the cycle and what's happening to prices,” explains Robert Brown, senior investment consultant at Watson Wyatt. “From a diversity perspective, people buy this argument, but the whole risk premium of commodities still makes it a tough story.”
But one manager blamed consultants, particularly in the UK, for not selling the story better to investors. And managers point out that the high volatility of commodities must be put into the context of the total portfolio, meaning the asset class may be volatile in itself, but lowers the total risk through diversification. “There has been a view that commodities have very high volatility and occasional run ups in price, but if you look at the longer run numbers, they are reasonably comparative to equities, which nobody questions has a role in institutional portfolios,” says Hooker.
Managers also dismiss concerns that commodities may have run their course. One pension fund manager at a mid-size UK pension fund, for example, said he would not consider the asset class because he had already ‘missed the boat’, and because the complexity of the asset class, compared with the relatively low allocation it would have meant it was costly and time consuming to consider.
It is an argument that irks many players. Bob Greer, senior vice-president and manager of real return products at Pimco, was the first to define an investible commodities index and a decade ago advocate it as a separate asset class. He believes the argument about performance misses the point. “The fact that we have had high returns is absolutely not a reason to invest in commodities,” he says. “And investors should buy for both inflation hedging and diversification. And finally, you have to evaluate the asset class not all by itself but based on its impact on the total portfolio. You don’t want an investor to look at commodities and say it has had great years and so I’m going to jump on board. And conversely, just because they’ve had good returns – that’s no reason to avoid the asset class.”
Pimco, which is one of the world’s largest commodities players with over $9bn (E7.4bn) in commodity mandates, created the first fund which uses TIPS (inflation-indexed treasuries) as the collateral for long-only commodities futures. The firm also has a large mutual fund in the US which tracks the commodities index, the CommodityRealReturn Strategy Fund, and also a Luxembourg product. Pimco says its real-return strategies, which include inflation-linked bonds and commodities, is its fastest growing area of business.
Greer also believes that the fear of market slowdown, spearheaded by a slowdown in the Chinese economy, is unfounded. China has been a major contributor to the global commodity demand but Pimco points out that even a slowdown to 4% growth would have little impact on commodity investors, because investors in indices are mostly exposed to commodities that are consumed, such as food or energy. Other commodities, like steel and concrete, which may be impacted by slower growth and slower infrastructure development, are not generally included in investible indices.
“We have had underinvestment in commodities at a time when global demand has continued to slowly grow,” points out Greer. “The demand is now increasing because you have emerging economies, particularly China and India, which are becoming more urbanised. Per capita demand has increased from emerging economies, at the same time that these economies are becoming more important to the global
He also argues that infrastructure is not keeping up with demand. There must also be an increase in supply, storage and transportation capacity, while development of processing, storage and delivery of commodities also needs to be improved. This lack of supply flexibility has been another positive contributor to the factors that drive commodity index returns.
Still, many managers believe that investors will have to become more sophisticated as the market develops. “It’s fair to say we’re not going to see commodities indices like GSCI continue to trend higher and higher,” explains Kevin Norrish, head of commodities research at Barclays Capital. “The investment decision is now a more complicated one, and requires a bit more sophistication.”
Norrish believes that though many indicators point to a downturn in commodities, commodity returns are traditionally strong when the dollar is weak, for example, the rally has actually been driven by a structural move up in growth rates, with the base level for demand growth higher because of China. Still, a few years ago an institutional investor needed only to be exposed to the market to make money. That is not going to be the case going forward. Investors will have to consider which commodity sectors they wish to be exposed to and how the get that exposure. “Some sectors like copper and nickel and oil will continue to see tight markets,” Norrish explains. “But there are also other ways of getting exposure through structured products.”
At the end of last year, Barclays Capital launched the world’s first collateralised commodity obligation (CCO), a credit instrument which allows fixed income investors to access commodities using a debt style payoff. The product is structurally similar to a traditional collateralised synthetic obligation except that the underlying derivative assets are commodities trigger swaps, with trigger events being based on commodity price levels. Managers realise that investors need new ways of accessing the asset class.
Others are creating active products. Goldman Sachs, which already has a passive fund tracking the GSCI and a commodities hedge fund, has introduced an actively management commodity fund which aims to deliver 100 bps. “If you are just in the market for a beta exposure then you can get it for ‘free’ if you go to the large index providers,” explains Ruud Hendriks, head of institutional business development for continental Europe, the Middle East and Africa for Goldman Sachs. “If you are looking for alpha, you'd inevitably have to employ an active management strategy.”
Hooker also sees the potential. “We’ve had a couple of passive accounts for some time, we are moving into active and looking to increase both sides of the business,” he says.
But Hilary Till, a co-founder of US CTA manager Premia Capital, argues that the role of active commodities strategies is as a satellite to institutions' core exposure, which should be obtained via indexes. The reason, explains Till, is that with a commodity index, an investor is exposed to the inherent returns of the asset class. In an institutional framework, risk is managed through a careful combination which involves offsetting beta risks, something that active strategies may not provide on their own.
Pimco’s Greer believes that few investors will move into pure active at present. Those who are already comfortable with the asset class are looking at various ways of enhanced indexing instead, such as rolling the futures contract forward or rolling some components of the index more than others. And one pension fund points out that fee structures for active managers, as well as transaction costs, are still too high to make it attractive.
It is a problem some managers acknowledge. “Historically it has been commodity trading advisors with higher fee structures and less transparency,” says Hooker. “I think with institutional interest we’ll see more movement towards a benchmark-orientated explanatory process.”
But observers say there is still a long way to go to bring commodities into the institutional comfort zone. "I think there's still more to do on education,” says Watson Wyatt’s Brown. “My sense is that this will take place over the next year. There will be some funds that think seriously about investing, others will rule it out and some will wait for the right timing and there will probably be a degree of phasing of investments.”
And managers point out that it is a long-term game. “Over the long term, we believe commodities are a good asset class to be invested in,” says Goldman’s Hendriks. “Once everyone starts to invest, you'll probably get to a point where markets will get more efficient. However, this is some way off. You can see this already with some of the smaller sectors in the hedge fund universe.” And if commodities have even a small portion of success with institutions in the same way as hedge funds have, the market is here to stay.