Commodities may be the hot theme of the season but at a recent IQPC conference in London on portfolio diversification with commodities the debate about whether they should be a regular part of an investor’s portfolio assumed the proportion of a proper fire sparking off debates about what the asset class can offer and at what cost.
According to Barclays Global Investors’ former head of commodities strategy, Benno Meier, commodities exposure is to heavy equity investments what fire insurance is to fire hazard.
But before getting pension funds to buy insurance, the industry needs to conquer consultants, who appear not to have formed a ‘house view’ on commodities.
Because the asset class has not been at the top of consultants’ priority lists for years, their attitude to the asset class can be uneven, even within the same consulting firm.
And although they have generally formed an opinion on commodities, they express it as individuals because of a lack of a single firm-wide view, Meier explains.
He says he has noticed, however, that the general attitude is changing as pension funds start shopping around for diversification. So much
so that some of them have showed interest in commodities before their consultants.
On the other hand, more and more consulting firms are embarking on research work. “I take off my hat to consultants,” Meier says.
The attractive side of commodities is that the asset class entails relatively high returns and diversification .
Costs are also down due to increased competition and products on offer, not to mention that the market is liquid and transparent.
“Strong returns” during geopolitical or macroeconomic shocks are also on the cards, Meier says.
The best news he had for a pension fund ready to step in the commodities world, is that as long as institutional investors continued to be a small proportion of the market size, there is a case for commodities.
But volatility is a factor and the variety of indices, six or so, can conspire to dampen the enthusiasm of some investor’s who end up giving in rather than facing up to potential confusion.
Confusion can be the name of the game for commodities-beginners. Or as Watson Wyatt consultant, Alasdair Macdonald puts it, the “complication” curve is “growing exponentially”.
Macdonald told the conference that governance takes “long and hard work” and influences allocation to commodities, especially for small pension funds.
And while the complication curve thrives, the “governance line” is flat making commodities an option for funds that can afford a lot of governance.
“Pension funds are not piggy banks. They are not pots of money for a rainy day. They have to pay for their liabilities,” he pointed out.
Commodities would represent an option if done passively, hereby requiring low governance.
They also represented diversification away from equities. “For investors with a substantial equity allocation and confidence in the return case, a modest 3-5% allocation could be considered.”
Macdonald explained that funds were reluctant to consider diversification during the equity bull market, but following the equity market fall in the last few years, many are starting to put in place programmes of diversification, involving commodities as an option.
Commodities would probably at the top of the priority list he commented, but enhanced indexing was indicated to be the preferred route until the market develops further.
He mentioned Dutch and Swiss funds as diversification leaders in Europe, with UK, France and Belgium lagging behind.
In the UK, lack of time and resources are among the factors behind the slow commodities development, although pension funds’ conservative nature is also a factor.
While UK pension funds were presented as lounging in a commodities cautious zone, another conference speaker, Jelle Beenen, announced that the p60bn Dutch health care scheme PGGM had increased its allocation to commodities .
He told delegates that PGGM allocation to commodities went up from 4% to 5% at the beginning of the year, due to a new asset mix.
PGGM, the second largest Dutch scheme, made its first commodities allocation in 2000, committing $2bn (e1.6bn). Beenen said that at that time the investor sector of the market was worth $6bn.
The fund immediately burnt its fingers as the investment followed a period of negative returns in both equities and commodities.
Beenen said PGGM did not regret its strategic choice, although conceded that timing was a key factor in commodity investments.
“Adding commodities to a 30:55:15 equity, fixed income, real estate mix turned out to be very advantageous,” he says.

PGGM uses commodities futures or derivatives of these futures and cash investments in euro as collateral. But it makes no investment in physical commodities.
Beenen says that the fund found it essential to “focus on the picture”. PGGM’s investment is done through the Goldman Sachs Commodities Index (GSCI) and the AIG-Dow Jones indices.
“Many other indices did not satisfy all of PGGM’s requirements,” he said, explaining that the fund places great store on transparency and accountability.
He said that PGGM preferred energy because, although more volatile, it offers higher diversification and served as the “best hedge” during geopolitical crises.
PGGM sees its higher energy weighting as a strategic choice, based on a long-term analysis and using short horizons could “very risky”.
Not everyone was a fan of GSCI or generally an index-enthusiast at the conference.
Howard Simons, a strategist at US firm Bianco Research told delegates the commodity-based equity index Goldman Sachs Natural Resources Index (GSR) tracks the GSCI “erratically”.

Simons, who was providing the sceptical point of view at the conference, spoke in favour of separate allocation to commodities rather then via an index.
He argued that correlation of returns for many commodities are “statistically insignificant” and that energy markets volatility makes them a different asset group.
Yet the GSR is heavily energy oriented like the GSCI, which has a 73% energy exposure.
“If you want to trade crude oil from the long side, why do you need corn or sugar in the mix?” he observed.
Simons suggested index-linked investment in commodities would amount to diversification within a single asset class.
“No equity or fixed income index with such internal characteristics would be accepted as an investment benchmark,” he told delegates.
“Diversification should be across asset classes. Within an asset class, it is an unnecessary, expensive and most likely an unintentional hedge,” he added.
Investors should disaggregate the index into its separate components, to make a “market of commodities” rather than a “commodities market”, where both long and short positions can be pursued.
They should also move away from futures into structured notes and make them option-based to hedge against a loss potential.
The index-free strategy would not be viable only to big pension funds like PGGM, but could also be pursued by smaller funds.
“The expertise is available,” Simmons said, adding that “in a big organisation and even in a smaller one, people can do their homework and learn.”