As with hedge funds and private equity before them, commodities have generally been viewed by pension funds with a degree of scepticism. Many still see them as touch and go, a volatile asset class that comes and goes out of fashion. But that is changing. Analysts now believe commodities are a more stable investment, especially given the incessant demand for raw materials in developing countries like China and India. Pack-leading pension funds are now waking up to the benefits commodities add to their portfolios. "We have been investing in commodities for almost four years now," says Ilmarinen, Finland's innovative €21.6bn multi-employer scheme.  "And it has been a very successful programme," it adds.
Ilmarinen began its foray into commodities with more beta-type products that tracked indices. This has since evolved into investments in different sectors, individual commodity exposure, including relative value bets, and today's alpha structures that seek returns across the entire curve.
Ilmarinen explains this has involved structural contango trades, which are a type of non-perishable commodity future, distinct thematic bets on events in the energy market and investing assets away from the benchmark index.

Ilmarinen says the contango, the situation where, and the amount by which, the price of a commodity for future delivery is higher than the spot price, has become more common and steep, resulting in spot returns having to reach 20% to break even with cash. So a change of policy was considered. "Having reached a decent commodity exposure by early 2006, we decided to take some money off the table to address this problem of negative yield, and focus more instead on outperforming the over-stretched commodity indices," the scheme explains.  "As financial investors are crowding the commodities arena, outdoing each other in their eagerness to carry the price risk, the expected market risk premium has become negative. In our view, an asset class needs to have a positive expected long term market risk premium in order to defend its position in an investment portfolio," it continues.
Ilmarinen is not perturbed by the decline in yields. It says despite the notional value of these trades diminishing radically - notional meaning the value of the futures' underlying assets at spot price - its foray into commodities has gathered pace and continues to evolve. "At the start of 2006, we took a tactical decision to invest mainly actively in those parts of the commodities market where we saw mostly ‘hot money' as well as institutional ‘indexed money'," it comments.
Ilmarinen says this was designed to seek out areas where it could utilise its healthy balance sheet as well as large numbers of counterparties - the buyers and sellers involved in the contango futures trades - in order to find alpha.
"We identified three main areas where we could be successful in this endeavour," Ilmarinen explains. First was alternative roll strategies, conceived in early 2005, which saw Ilmarinen short the general index and go long in alternative roll strategies, either by rolling futures contracts outside the standard index, or rolling all contracts a few months ahead. This means gradually rolling down the futures to ‘put' - or sell - because the market has bottomed and the put price prices will increase. 
The second area was outperformance by exploiting the shape of individual commodity futures' yield curves. An example of this is ‘backwardation' in energy and metals futures. This is a market condition in which the futures price is lower in the distant delivery months than in the near delivery months, so selling off the futures now reaped bigger rewards.
The third alpha generator Ilmarinen identified was assets that have become overpriced due to excess popularity generated by reporting in financial investment literature, such as sell-side research. "A good example of this is the selling off of sugar in mid-2006 on the overheated biofuel saga," the scheme says.

The risks inherent to each of these alpha generators are very different and Ilmarinen says it has therefore developed a very balanced risk-efficient alpha portfolio. "Even though the trades are very individual, efforts have been made to produce an aggregate of the bets and our weightings in equities and bonds so that they can be linked to our overall portfolio and risk management."
As a result of the strategic down-scaling of commodity risk in the portfolio, Ilmarinen places emphasis on generating structural alpha. Since the beginning of the year, it says the commodities portfolio has outperformed by approximately 5% to an ex-ante - looking at future events - tracking error of less than 4%. 

Highlights and achievements
This is an impressive approach to investing in commodities, being both pro-active and measured. Commodities are a complex investment class and many pension schemes are understandably shy of them.
But Ilmarinen has understood the benefits of incorporating them and has gained the skills to invest in them using futures and seeking excess returns through structured alpha-generating programmes.
Even as yields have fallen, Ilmarinen has not been discouraged. Switching to an active management approach means its commodities investments continue to outperform with little risk, even taking into account speculation about the future.
Incorporating the risk commodities carry in the overall risk management policy ensures it will not impact the overall portfolios negatively, while taking an aggregate of the investments helps Ilmarinen maintain balance between them and its equity and bond portfolios.