Constructing a portfolio
The arguments in favour of including commodities as part of an overall institutional investment portfolio are strong. Many in the industry agree that including investment in raw materials - or at least investment in their indirect forms - gives pension funds valuable diversification benefits.
But commodities are very different from equities, and just how a pension fund goes about constructing a commodities portfolio is another matter. Regulations surrounding pension funds and commodities investment, say experts, can be a serious limitation.
“You have so many different regulatory issues across the world and in Europe, that only very few institutional investors are able to follow all the possible ways of investing in commodities,” says Philip Vorndran, CEO of CSAM in Germany, and senior investment strategist. “Across Europe it is still quite difficult to convince regulators that physical investment in commodities is OK for pension funds.”
Vorndran says CSAM has set up a mutual fund for retail and institutional clients based on the Goldman Sachs Commodity Index (GSCI). For CSAM, commodities investment is a medium-term micro strategy, and as such it is important not to have a bottom-up structure where certain classes would be overweighted.
“But it’s so important to be invested in commodities at all that an index is a good addition to the investment portfolio,” he says.
For clients who are not allowed from a regulatory point of view to invest in a commodity index fund, there are products available based on the shares of companies operating in certain commodity sectors. These include a commodity equity product and a precious metals equity product.
“Of course these products are equities, and also have the market risk,” says Vorndran. “From a pure portfolio-optimising rationale it is not the best.”
Benno Meier, f ormer head of indexed commodities strategy at Barclays Global Investors, says basically pension funds have four options when it comes to building a commodities portfolio. They can do it themselves using their own in-house resources and put together a portfolio of commodities futures contracts. Large investors such as PGGM and ABP are able to approach commodities in this way, he says.
The second option is to gain exposure to the asset class by using derivative instruments, but in a swap format. A third way, and this is a segment of the industry, which has seen a lot of development of late, is through a commodities investment fund, says Meier.
And a fourth option, which is more focused towards the retail rather than the institutional market, is to invest via an exchange-traded fund (ETF), he says.
How an investor gains access to commodities depends on their strategy, Meier adds. If it is an indexed strategy, then it makes sense to buy one of the indices available, the two most popular being the GSCI and the Dow Jones AIG Commodity Index (DJ/AIG-CI).
Some $35bn (e28.4bn) is traded in the GSCI, while $10bn goes into the DJ/AIG-CI, says Meier. Another $5bn is invested in another three indices, the Commodity Research Bureau (CRB), the Rogers International Commodities Index (RICI) and Deutsche Bank.
In Europe, the GSCI is the most popular index, he says, with most of the assets traded in the DJ/AIG-CI being US-based. The GSCI consists of 24 commodities, which are arranged into five subsectors: energy, industrial metals, precious metals, agriculture and livestock. Energy is heavily weighted within the index at 73.38%, with crude oil at 28.49% topping the weighting of any single component.
When investing in a commodities index via futures contracts, it is assumed an investor also invests the dollar as collateral. For example, with an investment of $100m underlying, the margin payment is just $10m. The balance would normally be invested in T-bills or some similar fixed-income instrument.
Meier explains that the commodities returns consist of three elements – the change in futures prices, the roll yield and the interest yield (from the fixed-income instrument).
The roll yield is unique to commodities, and comes about because investors do not actually take delivery of the raw material underlying their futures contracts. “You roll before you take delivery, that means you sell the current contract and buy a further delivery date,” he says.
Historically, this has produced a return. For the last 35 years, the roll yield has averaged 1.7% per annum, although in the 1990s it was just 0.53% and in 2000 was 0.43%. “There are concerns about whether it will continue,” he says.
“The index as a whole provides very strong diversification benefits. This is one of the main reasons why they institutions get into commodities,” says Meier.
Bob Greer, real return product manager at Pimco, says most of the pension funds that have invested in commodities have chosen as a benchmark a commodities index so they have a way of measuring performance. “Most pension funds end up utilising OTC derivatives to give exposure to commodities, rather than futures contracts,” he says. While it is theoretically possible to invest in the raw materials physically, not only is it more difficult but the returns are not as good, he notes.
“Some pension funds would use swaps while others would use structured notes,” says Greer. But whichever method they use, most would outsource commodities investment to an asset manager.
Using swaps, it is possible to get an investment which represents the returns an investor would get by holding and rolling forward commodity futures on a fully collateralised basis, says Greer. The investment manager also acts to manage the collateral.
A first step for pension funds is to determine how much exposure to commodities they want to have. This involves running some asset allocation study such as a classic mean variance optimiser. “It will typically tell them to invest 15-30%”, in commodities, he says. However, a pension fund would be unlikely to recommend any more than 5-10% commodities exposure to its investment committee, and even this lower allocation can still provide meaningful diversification.
For investors seeking exposure to commodities, says Kevin Rodgers, managing director and head of energy trading at Deutsche Bank, there is a continuum of approaches ranging from no exposure at all to full-scale active management of the individual commodities. “Every academic study ever done reckons you should add commodities to broad investment portfolios,” he says.
Just how much is seen as beneficial ranges from a few percent to 10-15% of total assets, he says. There is a wide range of strategies and investment instruments that can be used in the commodities sphere, he adds. “Almost anything you can do in forex or equities, you can do in commodities. The market is getting more sophisticated.” However, the underlying liquidity in commodities is lower than many other asset classes and the volatility is significantly higher, he says.
Investing in commodities-based financial instruments is not the only way of getting exposure to the asset class, says Rodgers. Another that is now becoming more prevalent is exposure to infrastructure. Some of the big pension funds and hedge funds are already involved in this and figures indicate that vast expansion is inevitable in this sector, he says.
The International Energy Agency (IEA) has said that over the next 25 years, $16trn is needed to upgrade the world’s energy infrastructure. “That has to come from somewhere,” says Rodgers. “It’s the new frontier in commodities investment as far as we’re concerned.”
Reforestation, for example, is a significant area for infrastructure investment. There are now numerous schemes to protect and replant hardwood sources in a sustainable way. “Because rainforests absorb carbon, you get carbon credit too,” he notes.