Commodities can provide portfolio diversification as well as a cushion against inflation shocks
- Pension funds may invest in commodities for their diversification benefits and to protect themselves against inflation shocks
- The choice of index and commodities needs to be decided
- Exposure via futures markets introduces new challenges
- Gold is arguably a special case as it has unique characteristics
There are no fundamental reasons why pension funds should expect to generate above-inflation returns from investment in commodities. That sets them apart from equities, bonds and property. But it does not mean commodities are without appeal.
There are two main grounds for including commodities in portfolios. They provide both a diversification opportunity and protection against unexpected inflation shocks such as that in the 1970s.
Peter Verbaken, head of liquid commodities at APG Asset Management in the Netherlands, is a strong advocate of such benefits. “Adding a small allocation of around 5% significantly improves the overall risk/return dynamics of the portfolio,” he says. “The actual return is of less importance and if it just kept up with inflation, the diversification benefits would still make it an attractive proposition.” APG’s pension fund clients typically have exposure of between 4% and 5% in their portfolio.
The UK’s Universities Superannuation Scheme (USS) takes a similar view. Since the sharp rise in oil prices about five years ago it has generally had an allocation of about 1% in commodities.
Even if commodity investment is accepted in principle this still leaves open the question of how best to structure a portfolio. That is where things can get tricky. No pension fund wishes to own warehouses full of copper, let alone pork bellies, soya beans and oil. A typical exposure is made through derivative markets based on trading specific indices.
The problem with commodity indices, though, is how they should be structured. One approach is to weight commodities according to global production. That is the route taken by the popular S&P Goldman Sachs Commodity index, which means that it has a 63% weighting to energy, 15% to agriculture, 11% to industrial metals and just 4% to gold (as of January 2019).
Other indices have different weights. The Bloomberg Commodity index, for example, places more importance on liquidity and economic significance and, as a result, has a 12% weighting to gold, and just 34% to energy with 18% to industrial metals.
APG invests by rolling futures on the underlying commodities but uses an enhanced version of the GSCI index as a benchmark.
USS uses a tailor-made index and also invests in energy futures directly says Mirko Cardinale, head of investment strategy and advice at USS Investment Management, the pension scheme’s wholly-owned investment division.
Using futures markets directly or through swaps priced off them may solve problems over storage but does introduce a serious problem with commodity investment that is often glossed over. Gains but also losses come from three different sources. The first is the changes in the headline spot prices of the commodities.
Second, is the return on the collateral used to back up investment in futures by an institutional investor that typically would not be leveraging its investment, so a $100m (€94m) investment via futures contracts would generate a Treasury bill-rate of interest on the capital.
The third, is the so-called ‘roll yield’ obtained through switching from a maturing futures contract to one of longer maturity.
In the case of energy futures, the longer-dated contracts have often stood at a lower price than maturing contracts, giving rise to a ‘backwardation’ in prices. This phenomenon exists because of the costs of storage which can be as high as 50-100% per year for commodities such as natural gas.
This is in contrast to the situation seen in financial futures markets and precious metals such as gold, where the longer-dated contracts are in ‘contango’. That is it is priced above maturing contracts. The theoretical forward price ignoring storage costs and dividends is the spot price plus the cost of borrowing.
“Adding a small allocation of around 5% significantly improves the overall risk/return dynamics of the portfolio”
In practice the size of the contango or backwardation for commodity futures can change rapidly. It reflects not only storage costs and interest rates but changing supply and demand which can make commodity investment far trickier than spot price movements would imply. The boom in investment in commodities from 2004-09 led to disappointing returns for pension funds. Historical backwardations used to justify future return estimates switched to contangos partly because of the weight of long-only purely financial investors coming into the markets.
In 2006, when oil went from $35 to $50 a barrel, the S&P GSCI index had a negative return of 14% because the energy markets were in contango. In 2007, with the markets in backwardation, the return was 32% when oil prices shifted from $50 to $80 a barrel. This July there was a slight backwardation in the Bloomberg futures term structure which means that rolling contracts would entail selling near term contracts at a higher price than the subsequent purchase of longer-dated contracts thereby generating a profit.
APG has dealt with the volatile roll yield issue by having a strategy of tilting its exposures to those commodities with the greatest backwardations while maintaining a tracking error to their GSCI benchmark of 4%. Smaller schemes without the ability to manage in-house, however, could find external managers able to manage commodities in a similar manner.
There is one commodity with characteristics that are arguably different from any others: gold. Many contend that its price is not linked to production as virtually all the gold ever produced is still available. Its real use is as a store of value.
As a result, Cardinale is sceptical on its usefulness as a specific allocation within pension portfolios. USS does not have a standalone allocation to gold although it does include it within its overall commodity exposure.
John Reade, head of research at the World Gold Council, the market development organisation for the gold industry, argues that the precious metal’s value is driven by demand. He says half of that is accounted for by the fast-growing behemoths of China and India, 7-8% is used in electronic goods, while central bank reserves provide a large source of stable demand. As the figure shows, gold and US stocks are positively correlated but less so in down markets.