Choosing the right medium
Investing in a commodities fund means gaining exposure to what? That is the puzzle for investors, who may understand the reasons why commodities are a good alternative but who have yet to find suitable investment vehicles.
The sudden popularity of commodities has exposed a lack of real choice of commodities funds.
There are a variety of products to consider, but they fall within a narrow range from fairly well established global resources funds to funds that match a broadly based commodities index. The newest products are a variation on the structured note idea, and it is in this area, where the investment banks have a major influence, that the most interesting commodity fund investment opportunities are likely to occur.
Anecdotally there has been a marked increased in pension fund allocations to commodity portfolios in the US. And there is certainly a lot of interest in Europe, but institutions are still working out where commodities fit in to their strategic asset allocation.
Indexed commodity funds have a role to play and Jim Rogers is certainly a strong advocate of this approach. A passive product will at the every least allow the investor to participate in commodity market movements on a cost-efficient basis. The Diapasan Rogers Commodity Index Fund tracks an index of Rogers’ own creation. He is convinced that investing in this way will suit most investors, if only because they will struggle to find top quality active managers in the commodities space.
Passive investors have a choice of mainstream commodity indices, be it 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, representing an unleveraged, long-only investment in commodity futures. Individual components qualify for inclusion in the GSCI on the basis of their liquidity and are weighted by their respective world production quantities. The DJ/AIG-CI 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. It limits exposure to the various asset classes; for example, energy exposure is capped at 33%. The GSCI's weightings are changeable, with energy currently accounting for more than 70%, which gives it a much higher risk profile.
The differences between the two indexes do not help in comparing the few established commodity funds. For example, in the US, Pimco’s Commodity Real Return Strategy uses derivatives to match the DJ/AIG-CI, and invests the remainder of the portfolio in high grade debt. The Oppenheimer Real Asset fund does the same but uses the GSCI.
The emphasis for commodity fund manager activity has been in metals, oil and gas. China is key to the strength of commodity markets, but in terms of trading activity it is the hedge fund community that may yet undermine confidence in the asset class. If, as Alan Greenspan suggests, hedge fund activity poses a threat to market stability, then that extends into the commodities area, since it appears that hedge funds are the second most significant driver of the commodities bull run after China.
Is there a case for saying you could incorporate your commodities exposure within a broad fund of hedge funds allocation? Almost certainly not; it would be better to invest with a proven, steady performing CTA. In terms of performance, returns from CTA managers as a group has not been impressive. According to recent Edhec figures, CTA global managers have produced an average annual return of 6.3% over the last four years, with an annualised standard deviation of 10.2% and Sharpe Ratio of 0.23.
In Europe, one of the most highly rated commodities investment vehicles is run by Barep Gestion. The Barep Commodity Arbitrage Fund trades a portfolio of precious metals, base metals and energy markets on a discretionary basis. Barep, the alternative investment division of SocGen, runs a variety of specialist asset class and multi-manager portfolios. The trading approach for the Commodity Arbitrage Fund is based on a combination of macro- and micro-economic analysis. The managers track changes in the supply/demand relationship and structural variables which could affect the prices of commodities.
The fall off in prices for commodity-linked stocks is reflected in poor returns from most fund managers in the sector so far this year. Rising global interest rates and a host of disappointing economic data have sent share prices and commodity prices lower. Fund performance has been particularly poor for funds with positions in diversified mining and metals companies, companies such as BHP Billiton.
First State Global Resources fund manager David Whitten says: “Following the recent pull-back in share prices, many resources companies are looking fairly priced on a valuation sense. Some of the major diversified resource companies like Brazil’s CVRD are looking particularly attractive. Nevertheless, the outlook for the sector remains mixed. Chinese economic growth continues to be strong, with recent data suggesting inflation is under control. This growth should help to support commodity prices at current levels.”
While the outlook is generally positive, though, Whitten is wary of a number of potential disruptions: “A global economic slowdown would negatively impact the sector. High oil prices also threaten to dampen economic activity and speculation about change in the Chinese currency regime is creating additional uncertainty for markets.”
Overall, Whitten’s team, which is based in Sydney, manages around US$1bn (€824m) of resources portfolios. The Global Resources Fund's benchmark is the HSBC Global Mining Index. The fund is also invested in the energy sector (some 30% currently).
Whitten says he is not influenced by short-term considerations of commodity prices: “We don't use that as a starting point to choose companies. Our objective is to invest in high-quality companies with a low cost of production. They have to be in the lower half of world cost statistics. We look at companies that are attempting to employ new production techniques to reduce costs. We also believe that commodity prices will inevitably fall due to cheaper production costs, so we avoid companies with low profit margins that are exposed to small fluctuations in commodity prices.”
The portfolio contains a number of companies supplying China – for example CVRD, Alumina, Impala Platinum – plus Chinese companies such as China Oilfield Services. Another major theme is Canadian oil sands, an area of interest because of large reserves, low costs and low political risk.
The structured products promoters could yet provide the solution for institutions looking for a suitable commodity investments. It allows 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. And the structure can provide the levels of protection that a pension fund requires.
Structured products allow investors to access alternative management strategies with individualised investment guidelines. The management style can be modified and adapted to meet the needs of investors looking for a dedicated service. As such, this option has real merit for an institution looking to gain the benefits of commodities exposure.
One of the most attractive packaged options currently is the structured product of the type being marketed by Dawnay Day Quantum, which incorporates a growth accelerator facility. Invested capital is directly exposed to an equally weighted basket of commodities. The products have a reasonably short term, typically four or five years depending on the cost of the protection at the time of each tranche issue. Protection of capital allows the product to combine good upside potential and a degree of certainty.
Frankfurt-based investment consultancy SaxHolbein has marketed a similar product, a structured note based on the DJ/AIG-CI. Expect to see more of these products if demand for commodity funds continues to be strong.