GLOBAL – Pension schemes are under-invested in commodities, which may continue to produce equity-like returns, according to a new study commissioned by fixed income management outfit PIMCO.
According to a PIMCO spokesperson, the study suggests that while many schemes have roughly 5% allocated to commodities, pension funds could allocate as much as 20% to the asset class.
She said that the low allocation could be “because pension funds don’t really understand commodities”.
However, she added that this research study “hopes to improve the level of understanding in the industry”.
The independent study, conducted by asset expert Ibbotson Associates, focused on the most efficient allocation to commodities as part of a strategic asset allocation technique.
To assess how commodities would have contributed to risk-adjusted returns in a strategic asset allocation alongside stocks, bonds and cash, the study analysed the role of commodities as represented by a composite of four commodity indices based on annual data from 1970 to 2004. This approach reduced any bias occurring in any one index, said PIMCO.
Commenting on the study’s findings, PIMCO real return product manager Bob Greer said: “No matter which set of returns was used in the Ibbotson study, including commodities in the opportunity set improved the risk-return characteristics of the portfolio, and usually significantly.
“Furthermore, commodities played an important and very significant role in the strategic asset allocations. Nevertheless, commodities are still often excluded from the opportunity set of investable asset classes.”
He added: “Given the inherent return of commodities which is not conditional on skill, there seems to be little risk that commodities will dramatically underperform the other asset classes on a risk-adjusted basis over any reasonably long time period.
“If anything, the risk is that commodities will continue to produce equity-like returns, in which case, current forward-looking strategic allocations to commodities are too low.”
The PIMCO spokesperson told IPE that the €196.3bn Dutch civil service scheme ABP and the €74.4bn Dutch healthcare pension fund PGGM were considered leaders in Europe in terms of investing in commodities.
However, in April, IPE reported that ABP and PGGM were among the three biggest Dutch schemes to be hit by negative commodity returns in the first quarter of 2006. This was largely due to over exposure to energy markets.
PGGM reported a -2.9% return on the asset class, ABP suffered a -3.1% return while the roughly €19bn metals industry fund PME posted a -1.8% return.
All three schemes told IPE it was unlikely they would change their overall allocation to commodities. They stated that they understood commodities were a volatile asset class, but that it reduced the overall risk of the scheme’s investment portfolios.
“We are long-term investors,” an ABP spokesperson told IPE at the time. “We didn’t change our equity allocation after three years of bad returns. We’re not going to change our allocation to commodities after two quarters of bad returns.”
In other news, Watson Wyatt Investment Consulting reported today that the use of derivatives by UK pension funds was continuing to grow rapidly, fuelling the inflation-linked market, which is expected to double in 2006.
According to senior investment consultant Nick Horsfall: “There is a broad realisation among pension funds and their sponsors that there are a variety of derivative instruments that can provide pension funds with protection, enhanced performance and a better match for liabilities.
“In addition, they are realising that derivatives can alter the nature of that risk in ways that are not possible in the cash markets.”
According to Watson Wyatt, pension funds are attracted to these strategies because they can increase efficiency in the portfolio while also reducing risk. In addition, they increase pension funds’ choice of investment options because they achieve exposures that are not possible through the use of physical securities.
“Pension funds have some very important questions they need to answer before entering these strategies, including legality for use, pricing transparency in the product, whether the entity selling the solution has the appropriate product and can manage the collateral and will the product do what is expected of it,” commented Horsfall.
The size of the UK market in 2005 for end users (excluding intra-bank trades and executions with insurers) was estimated by a number of banks at around £9bn (€13bn) up from £3bn in 2004, but based on the size of inflation-linked swap executions already completed this year by the firm, the market could exceed £20bn by year end, said Watson Wyatt.