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Impact Investing

IPE special report May 2018

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In September 2002, we introduced commodities as a new asset class to broaden our recommended asset allocation, as we believe that diversification will be of even greater importance in future years.
Unfortunately, defining the term commodity is far from straightforward. Different people have very different views on the subject and looking at a Reuters screen only adds to the confusion.
In this article, we assess what we believe to be the right definition and indicate, from an investment company standpoint, how to invest in commodities.
Are commodities an asset class in their own right? In a macro-economic context, it seems fair to assume that commodities are generally a synonym for energy, particularly with respect to price movements, pushing import prices either up or down for net energy-importing countries.
From an investment strategy viewpoint, the term commodity is mentioned in the same breath as energy and/or basic materials – two sectors that are represented in every stock market index system, be it MSCI, the Financial Times or any other broad index. However, as a specific asset class, commodities do not exist.
So, why haven’t we just defined these two sectors as comprising commodities? The answer must be viewed in the light of the objective of broadening our universe of asset classes to heighten the advantages of diversification. Because of their counter-cyclical nature compared to financial assets, commodities are an ideal addition to a portfolio looking to improve its risk-reward profile.
Obviously, the world we live in is very different from that of the last two decades. First, the successful fight against inflation, which brought down short- and long-term interest rates, has mainly run its course. Today, ‘reflation’ is presumably more of a concern for the central banks.
Secondly, a rise in the risk premium after 11 September abruptly replaced the peace dividend priced into markets after the collapse of the Soviet empire.
Thirdly, Asia, and in particular China, with its World Trade Organisation membership, is becoming increasingly likely to be the next driver of growth – not Europe or Euroland.
Finally, no near-term alternative has appeared on the horizon as a substitute for oil as the main energy resource.
A broader universe of asset classes is needed to reflect these changes. Reducing the commodity asset class to energy alone fails to capture the global shifts described above. Our understanding of commodities is much broader, encompassing industrial metals, precious metals, energy and even agricultural products.
Indeed, adding commodities to the list of asset classes has a positive impact on the risk/reward profile of a portfolio, because the Commodity Research Bureau (CRB) index shows a low correlation with different asset classes, namely equities and bonds.
Having characterised the universe and the objective, the next question concerns the appropriate benchmark index to use. We have a wide variety from which to choose!
The advantages of a composite index – such as that of the CRB, Standard & Poor’s Commodity Index or the Goldman Sachs index and others – are obvious. They track a broad range of commodities, from agricultural products, such as grain or livestock, to metal, energy, fibres and fertilisers. And that’s exactly where the problem lies. The various indices have very different constituents and weightings could not be more disparate.
Some indices drop out of the universe immediately because of their constituents, such as the IMF Index, which has no energy or precious metals component.
From our perspective, three composite indices seem worth looking at in more detail. First, the Standard & Poor’s Commodity Index covers a broad cross-section of commodities, tracking 17 goods aggregated in six sectors, including energy (44%, as at 16 June 2003), grains (19%), softs (12%), meat and livestock (11%), metal (8%) and fibre (6%). The weighting structure is based on the dollar value of the underlying futures markets. S&P excludes gold, which it considers to be a financial asset.
The CRB Futures Index immediately springs to mind as well. It is built out of 17 components with equal weighting, grouped into six clusters (energy, grains, industrials, livestock, precious metals and softs). Whilst the individual constituents are very similar to those that comprise the S&P Index, the fact that they are equally weighted makes this index very different.
A third composite, supplied by Goldman Sachs (GSCI), is world-production weighted. The average quantity of production in the past five years determines the quantity of each commodity in the index. In economic terms, the weighting reflects the use of the commodity in the economy.
However, we believe the CRB index looks to be the best choice. The Goldman Sachs index is very appealing because of the way it is constructed. However, its high energy weighting (more than 60%) rules it out in our view. Despite the fact that softs have a higher weighting in the CRB Index, we think this index is a good synonym for commodities due to a couple of reasons. First, the CRB index is widely recognised as the most reliable barometer of commodity price trends due to the diverse nature of the 17 commodities that comprise it. Thus, it serves as an excellent measure for macro-economic analysis.
Secondly, since it is equally weighted, no single commodity has undue impact on the index. The equal weighting reflects our own thinking, which differs from pure benchmark thinking (which usually prefers markets/sectors that have provided exceptional performance).
The most important question for investors/fund managers is obviously how to invest in commodities. We see several options.
Most (if not all) of the commodities we have mentioned are traded as futures, which could be used as investment vehicles. However, to alleviate the need to choose individual commodities in which to invest, the New York Futures Exchange in 1986 began offering futures contracts on the CRB Futures Index as an investment medium.
Another investment alternative is opening up at country level. As shown in the graph, countries that have a significantly higher commodity proportion than their peers – such as Australia – usually do better in periods of rising commodity prices.
Commodity investment goes beyond countries, however. Currencies of countries with a strong commodity base tend to trade in line with the fluctuations of commodity prices – admittedly with a high degree of volatility.
In conclusion, when considering the debate to invest or not to invest, despite the recent flat performance (year to date), we are sticking to our overweight recommendation. The energy and precious metal components should hold up, as uncertainty about the Middle East fails to fade immediately. On top of that, energy stocks offer good value. The CRB industrials component is less straightforward. Copper, which is an important ingredient in semiconductors, might trade on the riskier side of the balance due to weaker semiconductor sales.
Franz Wenzel is with the investment strategy team at AXA Investment Managers

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