Moving from passive to active
Pension funds are looking to commodities to generate alpha returns, finds Lynn Strongin Dodds
While the bulk of the money flowing into commodities has been of a passive nature, investors are becoming more proactive as oil and food prices continue to climb. Currently, there are not that many active funds on the table, but this is changing. Asset managers have either already launched funds or are exploring the different ways to generate those much-sought-after alpha returns.
The popularity of commodities has been well documented. In the past two years alone, assets tracking the S&P GSCI, the most widely used commodity index, leapfrogged from $60bn (€38.6bn) at the end of 2006 to about $100bn today.
Over the same period, assets in the Dow Jones AIG index rose from $30bn to $50bn. Diversification and non-correlation with bonds and equities were the main attractions. Industry reports show that over the past 40 years, commodity prices frequently rose when equity and bonds prices were bumping along the bottom.
More recently, their inflation-hedging attributes have come to the fore. Whereas equities and bonds tend to react negatively to unexpected jumps in inflation, commodities often enjoy increasing returns in such situations. This is mainly due to the fact that commodities themselves are a component of inflation.
Ali Lowe, global asset allocation and currency chief investment officer of State Street, says: "What we have seen with commodities is the classic evolution of an asset class. Investors started off with index funds but then as they became more comfortable and sophisticated they decided to look for a more active strategy. Also, the easy asset class gains are gone and investors need active strategies in order to make the money work harder for them and generate a better return."
"Investors are looking for strategies that are profitable regardless of the direction of the commodities markets," says Ted Frith, senior European sales manager at Aspect Capital. "One of the biggest debates at the moment is whether prices have been impacted by the significant amount of money that has been flowing into the markets or whether the price moves have attracted the money. I believe it is the latter."
Frith is not alone. The general consensus is that the old fashioned economic dynamics of rising demand and limited supply are underpinning the soaring prices.
Over the past five years, producers have not been able to keep pace with the staggering appetite from emerging markets such as China and India which are aggressively modernising their economies. At the same time, their developed counterparts have not significantly reduced their consumption. Add a combination of reserve base exhaustion, labour and equipment shortages to the mix and it is no wonder that commodities such as oil, agriculture and metals are at record levels.
"The flow of investment money into commodity markets remains relatively small compared with investments in equities and bonds," says Kevin Norrish, director at Barclays Capital commodities research. "More importantly it is also small relative to measures of commodity market size, both financial and physical. Fundamentals, not speculative activity, remain the key drivers of commodity prices."
Barclays Capital has responded to investor demand for active strategies by launching its commodities outperformance roll-adjusted liquid strategy (Corals) index. The 12-commodity index is designed to capture alpha from the commodity markets through in-depth fundamental and technical analysis, according to Shachi Shah, head of Barclays Capital Fund Solutions.
The Corals index aims to extract positive returns in differing market cycles, including stagnant or falling markets, utilising a long-short strategy. It also hopes to exploit the lack of correlation between its commodities and other asset classes, and to hedge inflation by investing in those commodities that are contributing to rising prices.
However, Hermes Fund Management is testing the waters with two new products for the BT Pension Scheme (BTPS), the UK's largest with £37bn (€47bn) in assets under management. The BT fund has switched about £250m out of its existing £1bn passive portfolio, which tracks the Goldman Sachs Light Energy Index, into the Hermes commodities index plus fund. The fund is managed against the same benchmark used by the passive fund but it seeks to outperform the index by 3% per annum.
A new slug of £100m has been slotted into the Hermes commodities alpha fund, a fully active portfolio with a mandate to beat LIBOR by 3% a year. At the moment, neither fund is being marketed to third parties, although this could change.
"We wanted to add greater value over the index but we did not feel that was necessarily appropriate within the existing index fund," says Andrew Raisman, marketing director at Hermes. "The aim of the existing fund is to give investors the commodities beta, using modified index rolling at the margin to add some limited extra return. But we did not want to introduce too much extra risk. The new funds take this modified index roll further and, depending on market conditions, aim to deliver alpha on top of the index return."
State Street Global Advisors has also opted to use futures to underweight and overweight the benchmark index. Its multi-source active commodity strategy targets the Dow Jones AIG because it believes it is broader and more diversified than the S&P GSCI, according to Lowe. The main focus is to unearth opportunities to improve on any of the three components of a total return - price and roll or the return on cash posted as collateral to hold the futures positions.
When the price of a commodity to be delivered in two months is greater than its current price, the futures contract is in what is called a state of contango. This means the investor has a negative roll yield and is forced each month to buy contracts at a higher price than the current, or spot, price. To combat this problem, investors can take short positions in the index and long positions in future contracts that have a positive roll yield, or are in backwardation.
"The advantages of an active strategy is that if you see a strong trend emerging you can jump on it but if it is going downwards, you can also jump off," says Lowe. "For example, we are now underweight cotton and sugar because prices have dropped dramatically. We are overweight oil partly because it is currently in backwardation although 18 months ago was in contango".
Schroders also invests via future contracts using a fundamentally driven research approach, according to Matthew Michael, product manager, emerging market debt and commodities. "Diversification is the key to investing in the asset class, both at a portfolio level and in the futures markets that we use. For example, for coffee and sugar we trade on both the London and US markets. Altogether, there are about 25 to 30 commodities included in the available commodity indices, but we see opportunities in far greater number. We invest globally and if we see an opportunity where there is no future, such as uranium or potash which is used for fertiliser, we will buy the stock of a producing company."
Other fund management groups such as Insight Investment have adopted an equity, as well as futures-based approach.
"We are focusing on agricultural stocks with the themes revolving around food, feed and bio fuels," says Ana Cukic, co-head of Insight's multi-asset group. "This is because of the supply and demand imbalances. We are investing in companies that are involved in seeds, fertilisers, water processing, farm machinery and logistics such as storing and processing. We are also keen on natural gas, which has lagged behind oil prices and is trading at a discount. Through a structured product, we are now buying long-dated contracts for 2011 because we think the discount will narrow as natural gas is a much cleaner fuel than oil and coal."
However, Baring Asset Management is taking the equities path and focusing on the energy, chemicals, precious metals and soft agricultural sectors. "We have a five-factor investment framework which is applied to the assessment of our investment opportunities - growth, liquidity, currency, management and valuation," notes Jonathan Blake, manager of the Baring Global Resource Fund.
"Although the stock markets may exhibit volatility, we look at the fundamental attractions of the opportunities. For example, we are increasing our exposure to energy but may differ from our competitors in that we are specifically looking at national companies. This is because we expect them to be awarded new production licences which in the past would go to the international major oil companies."
Baring is also expected to launch a new agricultural fund, which will invest in agriculture-related stocks from seed manufacturers to farming equipment makers, fertiliser companies and food manufacturers and retailers.
Another option that is gaining traction in the active space is exchange-traded commodities (ETCs). Nicholas Brooks, head of research and investment strategy at ETF Securities, says: "We are increasingly seeing investors use ETFs because they are a quick, efficient and cheap way to get access to the themes that are playing out across the commodity markets."