Rising inflation and falling stock markets are two good reasons for US pension funds to diversify their investments out of traditional assets, especially in favour of commodities. The trend that started last year among state sponsored systems is gaining momentum with a new twist: managers are no longer betting only passively on commodity indexes, but are also trying active strategies looking for enhanced returns.

The bellwether is the $240bn (€153bn) California Public Employees' Retirement System (CalPERS). Last year it invested $450m in the Goldman Sachs Commodities Total Return index of more than two dozen natural resources products, explaining that "global demand for natural resources and proved systems to extract and deliver them will only increase". CalPERS managers added that they would "look into commodities future contracts and related investments to naturally complement, diversify and add value to [the fund's] expanding securities investments in energy and raw materials."

CalPERS has since increased its commitment to this sector while creating a whole new asset class - inflation-linked asset class (ILAC) - for investments in forest land and bonds, besides commodities. ILAC's goal is to "provide a hedge against inflation while diversifying investments, thus mitigating losses during equity market downturns" and to achieve returns exceeding the consumer price index by at least 5% per year.

The fund has approximately $2bn invested in ILAC sectors, with a target allocation of 5% of total CalPERS market value over the next three years; commodities exposure alone may increase to 3% of its portfolio or as much as $7.2bn by 2010. Part of this money will be actively managed allowing that "the risk exposure of the investment instruments may be long or short, or a combination of both".

That is the right strategy, according to a new study by Ennis Knupp & Associates, which urges investors willing to invest in commodities to avoid indexing in favour of active managers. "Over the last two years, investors have funnelled over $50bn into indexed futures investment," says the study. "The result of this additional demand for investments in commodity futures has served to move many futures markets into contango," which is when the futures price is above the expected future spot price. "This investment has increased the price and reduced the expected return of many commodity investments."

Institutional investors now have $160bn invested in commodities, up from $40bn five years ago. According to Daniel Raab, managing director at AIG Financial Products, New York, $155bn are invested long-only in commodities, mostly passively tracking either the Dow Jones AIG Commodities index or the S&P GSCI. A recent survey by Russell Investments of North American pension funds and other institutional investors confirms that they mostly invest passively in commodities: 11% of them do so against 6% that are actively invested in the same asset class. But 20% of respondents are considering active investments in commodities.

Another US public pension fund that is increasing its exposure to commodities is the $81bn New Jersey State's Retirement System. Two years ago it adopted a plan to move 18% of assets into alternative investments, including hedge funds, real estate, private equity and commodities. Last September it decided to invest $200-500m in commodities with Gresham Investment Management and an additional $200-500m in a commodity fund run by Schroder. In February it added another $500m in commodities.

Such a strategy may pay well, as the Pennsylvania Public School Employees' Retirement System (PSERS) shows. This $64bn pension fund holds about $3.3bn of its in assets in commodities, as part of an investment programme adopted in late 2006, and about 80% of its commodities investments are actively managed. To diversify risks, the five managers are allowed to take positions against or for, overweight or underweight the Dow Jones-AIG Commodity Index. Thanks to commodities and the other alternative investments, PSERS returned 13.8% in 2007, outperforming US stock and bond indices.

In Canada the Ontario Teachers' Pension Plan has about 2% of its CAD106bn (€66bn) in investments allocated to commodities. Seven in-house managers take care of its commodities portfolio, aiming to beat the GSCI with futures, swaps, long and short positions.