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Pension schemes continue to embrace alternative investments as a means to diversify, but commodities continues to be one of the least understood of the “alternatives”.

There are a lot of factors that trustees must consider before embarking on commodity investments, both in terms of incentives and reasons to be cautious.

Commodities are different to markets pension funds are generally used to investing in, such as equity markets. Commodity markets offer detachment from the main economic cycles, as they have very low correlation with other markets, as well as the chance to generate returns from multiple sources at the same time.

STOXX’s managing director Lars Hamich says: “Commodities markets are as diverse as equities markets worldwide. Market cycles differ tremendously and so do prices as well as the importance to national economics.

“Traditionally, the energy sector has always been the focus of investors. Other sectors such as soft commodities or alternative energies have gained the attention of the investment community recently.”

State Street Global Advisor’s senior mana-ging director Alistair Lowe says the main differences of commodities are the different types of return and the buying of contracts rather than physical assets.

Lowe explains: “The biggest difference is, as an institutional investor you are always gaining exposure through futures or other derivative contracts based upon them. You are not going out there and buying a barrel of oil, some live hogs and a tonne of corn.”

Another difference trustees need to be aware of is the ability to invest without putting in all the capital upfront.

Lowe says: “Let’s assume you are buying futures. As with any futures contract you have some cash collateral with which you need to back it.
“If I buy $100m [£50m] of oil, I do not need to put $100m of cash down – unlike equity. What I need to do is post an initial margin – perhaps 5pc of that value – with the futures exchange, and the rest of cash I have sitting earning interest somewhere. So, the difference is you do not have to pay 100 cents on the dollar.”

It is also worth noting that commodities have a different return structure to other asset classes. While schemes can benefit from price returns and dividend returns when investing in equities, commodity investment also offer a basic cash return whereby investors can sell their contracts.

As the spot price of the commodity goes up and down, the value of the contract will rise or fall. This is known as roll return and is a concept that has been receiving a lot of attention from investors recently.

Assuming the spot price is held constant, a futures contract holder will earn a positive roll return if the price of the futures contract is lower than the spot price. This is known as backwardation.

Lowe explains: “If you have bought a large oil futures contract, at the start of March, for instance, you would want to sell the March contract, buy April’s contract and roll it forward overtime. Over long periods of time you typically get a positive return in the energy complex from rolling your contracts.”

The opposite of backwardation is contango, which Lowe says is the cycle the oil market is currently in. If an investor is trading in oil, there is a futures contract being sold for each month, sometimes years in advance. In the current market, subsequent futures contracts are selling for more than their predecessors, leading to investors losing money.

Lowe explains: “That means that if you are passively rolling every month, you are losing money because you are buying the next contract for more than the current one. So there’s been a lot of discussion recently that the roll return has been negative for some time and that the benefits have gone away forever.”

However, Lowe, like others, does not believe this is the case, citing the fact that oil was in contango in the late 1990s and subsequently recovered.

He adds: “What typically happens is when a market is in contango, from an arbitrage point of view it encourages investors to build stocks. In the last year is the stocks have built up. As more and more oil sits in containers the price goes down.

“We saw the same thing in 1996 through 1998 when the market went into contango: stocks gradually built and prices went down and down. What happened after that? Suddenly the price started running up again and oil went back into backwardation, giving investors positive spot returns and positive roll returns again. My view is this is temporary, it is part of the cycle we have seen happening many times before in history.”

Perhaps the most convincing reason why schemes should be considering commodity investments is its promise to provide excellent diversification benefits.

According to FourWinds Capital Management’s chief executive Kimberly Tara the asset class offers a wide variety of risk profiles and represents an excellent way to diversify a portfolio.

She says: “Commodities as an asset class includes a wide and varied selection of risk/return profiles that offer important diversification benefits for a pension portfolio.

“Commodities markets include more than just exchange traded contracts; water, timber and many of the planet’s key resources are essential long-term commodity investments that can offer substantial benefits to pension fund portfolios.”

Blake agrees commodities offer great diversification benefits.

He says: “There has been much written on the benefits of adding commodities in order to diversify a portfolio’s return volatility as a consequence of their relatively low correlation with other assets over time. Furthermore, some investors add commodity futures to their portfolios in order to hedge against inflation.”

Lowe says a key benefit of commodities is that they not only offer portfolio diversification but they also perform well against other assets.
He explains: “We believe commodities give you a long-term real return, but more importantly they tend to do well at times when equities and bonds – which dominate traditional portfolios – are doing badly.

“Over many cycles, there are times when commodity prices rise. If there’s a supply shock which hurts the real economy, commodities make money. If an investor’s equities go down because of a shock to the economy – or towards the end of an economic cycle as things start to overheat – commodity prices rise due to the booming demand. The bond markets get worried about rising inflation and overheating, and you lose money on your bonds while making money on commodities.”

Accessibility and investment approaches
As has been illustrated, commodities potentially offer an excellent means for diversification because they offer many advanced investment opportunities. But it is this required high level of investment sophistication that can prove to be the asset class’ mixed blessing.

Tara says commodities are an excellent diversifier, but also warns they are a “new and unfamiliar” asset class and “concentrated positions may be ill-advised”.

Lowe agrees diversification opportunities are its greatest advantage, and says a lack of overall understanding of the asset class is its biggest disadvantage, especially where trustees of pensions schemes are concerned.

He says: “Obviously trustees aren’t as aware of what commodities are and so it can take a long time to educate them and ensure they are comfortable with the asset class.”

Another disadvantage, according to Lowe, is there are not as many respected institutional investment managers which run commodity investment programmes as there are those which manage more traditional investments like equities and bonds. Lowe says commodities are more often associated with specialist commodity trading advisers and the hedge fund community.

Lowe adds: “Firms are asking themselves do they have the resources to build a team and credible investment programmes, and, if they do, how many clients will it attract?

“There are a smaller number of people who have the experience, infrastructure and risk management to be able to invest successfully in commodities than in other asset classes.”

However, there are ways that schemes can gain access to commodities, from individual commodity futures to exchange traded funds (which are backed by the underlying commodity), and commodity indices, such as the Goldman Sachs and DJ-AIG Commodity indices (these track the underlying commodity price movements through the use of futures).

Baring Global Resources Fund’s manager Jonathan Blake says: “Investors can also gain indirect access to the underlying metals price movements by investing in equities, in shares of those companies which are closely involved in these sectors or alternatively in broader asset class funds, like the Barings Global Resources Fund, which gives exposure to a broader selection of companies operating and linked to commodities.

“Each of these investment vehicles requires different levels of management by an investor, from risk monitoring and reporting to the selection and timing of any investment in the underlying commodities.”

Mercer Investment Consulting’s most recent survey figures show that greater (albeit modest) interest in commodities is indeed being shown, although more so continental schemes than those based in the UK.

Hamich agrees there has been increased interest in commodities over the past few years and says the main reason is simply performance.
He explains: “The Dow Jones AIG Industrial Metals Index shows a five-year annualised return of 26.6pc, whereas the Dow Jones Global Titans 50 Index, the global blue-chip index comprising the 50 largest companies worldwide, only gained 4.4pc annually over the last five years.”

If there is this greater interest, what is the best way for schemes to gain exposure to commodities?

Lowe says investors have two options: “Firstly, tracking a broad passive index-like approach, benchmarked to the two indices – the Dow Jones AIG and the Goldman Sachs commodity index are probably the two best well-diversified indices out there.

“The other option is taking an active management approach for the core allocation. For a pension fund we recommend an index-based approach. If you are going active we recommend that it be with someone who is starting from the index and taking risk control bets against the index so you’re still getting that core long-term asset class exposure.

Blake says: “How a pension funds gains exposure to commodities depends on the investor’s underlying rationale for making the investment in the asset class, their own risk profile and return expectations and the ability to manage the investment.”

Tara advocates taking an active approach.

She explains: “The unique nature of exchange traded commodities, in particular the roll yield, means that actively managed strategies are preferable to index vehicles. Active products offer controlled volatility, most importantly on the downside.

“It is important to also look at multiple strategies – for example, discretionary, systematic and long/short equity – to respond tactically to the dynamics of each underlying market. It is generally best to invest in a vehicle that diversifies across the three main sectors – energy, metals, and agriculture – to assure that cross-correlations will reduce the volatility of the investment vehicle.”

Blake says the decision as to whether a scheme should invest in a particular commodity group or not depends on whether the aim is to actively move between commodity groups as conditions allow.

He explains: “Indices provide a relatively straightforward way of investing in commodities but can be influenced by flows in and out of the asset class, as well as from the effects of broader index rebalancing as and when they occur.

“The benefit of investing in a fund like the Baring Global Resources Fund is that the sector allocation, stock selection and timing decision are taken by that fund’s investment manager rather than the pension fund itself, thereby utilising the expertise of that manager within that asset class.”


Tara agrees that it is appropriate for funds to go after specific commodities depending on the investor’s portfolio objectives and needs.
She says: “Certain commodities or natural resources can offer a response to specific investor needs. As an example, timber is a commodity that has almost bond-like characteristics as well as a clear non-correlation to traditional investments. Another example might be agriculture, which is a commodity sector where the contracts are often not correlated to each other and can offer an attractive diversifier for pension portfolios.”

However, Lowe argues strongly against investing only in particular commodities and instead advocates strong diversification.

He says: “Investors should be building a well-diversified portfolio of commodities because that way they gain more stable returns.

“We preach that diversification is your friend. Within commodities there are times when the oil complex is doing well, or badly as it’s done more recently, but agricultural might be doing well. Industrial metals will do well or badly at different times, and, even then, aluminium could be doing well while nickel could be doing badly. So we say diversification is good.”

Hamich agrees that the greater the diversification within a commodities portfolio the better.

He explains: “Commodities markets can be fairly volatile. The Dow Jones AIG Industrial Metals Index, for example, shows a 250-days volatility of 33.6pc, which exceeds the 8.5pc of the Dow Jones Global Titans 50 Index by 25pc. In addition, commodities sectors follow different market cycles and correlate very little or sometimes not at all.

“Diversification should reduce risk and enable schemes to participate in rising market cycles. Index-linked investment products offer ideal options to diversify commodities exposure.”

Is the time right?
If schemes are interested in gaining exposure to commodity markets, is now the right time to start – or increase – allocating funds?
Analysts have already proved divided over the possibility that commodities are entering 2007 in the early stages of a bull market. Some have argued that 2006’s record prices have already signalled the beginning of a downturn.

Lowe, however, believes now is a good time for investors to add commodities to their portfolio or increase their allocation.

He explains: “We think it is always hard to predict very short-term moves, but we think strategically we are in a commodities super cycle. That is being driven by a chronic underinvestment in supply, particularly in the metal and oil complexes.

“In the late 1990s prices were low, so all the oil companies weren’t investing any money in new supply. There is a long lag in increasing supply, particularly in oil but even in industrial metals.

Furthermore, Blake suggests that India, China and Brazil represent three countries which are going through an early stage of economic growth “where people go from having a bicycle, a candle and a kerosene lamp to having a scooter and electricity reliable enough for light, but not yet for fridges – to being able to afford a fridge, air conditioning and a car.

He adds: “There are huge numbers of people going through that cycle where the use of commodities per capita goes up dramatically, and we think that boom is going to continue.”

Blake says although the year has started slowly for commodities as an overall asset class, he thinks the market will remain strong for 2007.
He says: “Base metals fundamentals, in particular, remain firm given the relatively low levels of inventories, plus the potential for supply disruptions and continuing robust global demand backdrop.

“We do expect oil prices to continue to trade within a broad range, but with non-OPEC supply increasing and spare capacity building within the sector, we believe there are more attractive opportunities elsewhere, at least in the short term.

“We also remain positive on precious metals, particularly platinum group metals and uranium, which we believe will be supported by the ongoing tightening emission legislation for cars and the increasing focus on nuclear power.”

There are a number of reasons why schemes should be considering gaining exposure to commodities, although there are perhaps as many reasons why trustees have a right to be cautious and inquisitive.

Differing forecasts for 2007 only complicate the issue. What is certain is that trustees should not be ignoring what is a potentially invaluable investment opportunity.