Natalie Dempster, head of investment North America at World Gold Council, looks at benefits and risks of investing in commodities, using the Missouri State Employees' Retirement System as a case study
There are an increasing number of plan sponsors, foundations and endowments making strategic allocations to commodities. According to Standard & Poors (S&P), at the beginning of 2008, 78 US funds had positions in commodities. Of the 70 funds that S&P provides details for, the total dollar value of all allocations was US$6.4bn, putting the average allocation at 2.7% of the funds under management. 13F filings from the Securities and Exchange Commission (SEC)1 also identify that by the end of September 2008, three large North American funds had made sizeable direct allocations to gold via SPDR® Gold Shares (formerly StreetTRACKS Gold Shares), the market leading gold ETF.
A thought leader in this field is Missouri State Employees’ Retirement System (MOSERS), having made its first investment in commodities in 1998, a near first for either a US public or corporate plan sponsor. The decision has paid off handsomely. An investment in commodities has provided MOSERS with diversification benefits and protection against inflation, both of which have turned out to be crucial in the current economic and financial landscape. The investment has helped MOSERS become one of the best performing funds in its peer group, posting an impressive annualised return of 9.2% in the 10 years to June 2007. World Gold Council has put together a case study of this programme looking at the driving force, perceived benefits and risks, and implementation strategy behind MOSERS’ decision to invest in commodities.
The initial push to invest in commodities came from the MOSERS internal investment team who felt that the principal appeal of commodities was that: “they were truly different than any of the other assets in MOSERS portfolio”. In each year since 19702 that equities posted negative returns, commodities had outperformed, and hence the team believed an allocation to commodities would have helped to limit the downside risk.
Diversification is shown to reduce the likelihood of substantial losses arising from a change in macro-economic, geopolitical or financial conditions which can be particularly damaging for individual asset classes. The MOSERS team analysed research which indicated that “an allocation of as little as 5% to commodities can lower the risk in a portfolio substantially, with returns staying about the same”. This is in line with joint World Gold Council/New Frontier Advisors3 research on the role of gold as a strategic asset, which found that only a small amount of gold was required to enhance risk adjusted returns: 1% to 2% in a low risk portfolio and 2% to 4% in a medium-risk one.
It is important to note that the team did not expect an investment in commodities to boost returns. Rather, their strategy was designed to lower the risk or volatility of portfolio returns. This would in turn help MOSERS to smooth changes in the annual contribution rates it requested from the state government.
The team’s other main motivation for looking at commodities was inflation protection, which is especially pertinent for public funds as state retiree benefits are usually subject to an annual cost-of-living-allowance (COLAs). COLAs are typically based on national inflation indices: in MOSERS case, on the Consumer Price Index for All Urban Consumers (CPI-U). Indeed, one of MOSERS stated investment objectives is to have an annual real return in excess of 5%, real return being defined as the nominal return less the CPI-U.
Traditional assets, like bonds and equities, often perform poorly in a high inflation environment. By contrast, the team noted that: “While unexpected inflation provides the best environment for commodities, expected inflation provides a favourable set of conditions for commodity price increases. Oil, metals, coffee, sugar and cattle prices have all benefited from, and in some cases, have been the foundation of inflation in finished goods prices in the past”. They gave the example of the 1970s when commodities posted very high returns: “High oil prices, due to the embargo and rampant inflation, produced returns from commodities that were substantially above average. At the same time this was a period of extreme difficulty for both stocks and bonds”.
There were no state regulatory barriers preventing MOSERS from investing in commodities, which would have been a key hurdle for other public plans at that time. Rather, the main challenge the internal team faced in its quest to add commodities to MOSERS’ portfolio was a general lack of understanding about investing in commodities by MOSERS’ board of trustees. Commodities were simply viewed as too volatile and too speculative for the fund. Commodities futures are, after all, highly leveraged instruments, with only a small upfront payment required to gain a large exposure to the underlying asset. Fortunes can be made, but they can also be quickly lost. There was also some confusion among the board as to how to gain exposure to the commodities market. Would physical delivery be required?
Education was therefore required – this meant not only stressing the potential benefits of investing in commodities but also addressing the perceived risks. For example, the team highlighted that while commodities can be volatile at times, volatility per se is only really undesirable when an asset is viewed in isolation. By contrast, when it is being added to a portfolio of uncorrelated assets, a volatile asset can in fact help to mitigate downside risks, as the price can move sharply upwards when the value of other assets is falling. The team also stressed that any investment in commodities would be made via a commodities basket, which would at any rate diversify the risk of investing in a single commodity.
As an aside, it is worth pointing out that gold has historically been even less volatile than commodity baskets. In the ten years to end June 2007, annualised gold price volatility averaged 14%, compared with 21.2% for the Goldman Sachs Commodity Index (GSCI).
MOSERS also decided that any investment would be made on a long-only and fully collateralised basis, eliminating the risks involved in short selling where investors can lose multiples of their original investment and leverage. In the case of a fully collateralised future, an investor buys the equivalent face value of the futures contracts in liquid assets, typically US Treasury bills. The investor then adds or withdraws money from that account based on daily changes in the mark-to-market value of the futures contracts.
The education process was successful and MOSERS made its initial foray into commodities in 1998 through the GSCI, essentially the only major publicly-quoted index available at the time. The decision has paid off, helping MOSERS become one of the best performing funds in its peer group.
MOSERS initially allocated 2.5% of its total assets to the GSCI. In the years that followed, it sought to add alpha by, inter alia, managing the timing of the rolls on its commodity futures and, later on, switching to commodity swaps from commodity futures in order to take advantage of the relative change in prices. Today, 3% of the fund’s assets reside in commodities, and the CIO (with the approval of external consultants and the executive director) has the flexibility to invest as much as 6% or nothing at all, allowing the fund to quickly take advantage of any change in market conditions.
Commitment to commodities
Ten years on, the World Gold Council asked MOSERS chief investment officer, Rick Dahl, whether the investment in commodities had achieved the fund’s desired objectives. According to Dahl, commodities had “more than achieved” what the team had hoped for in both areas, which have turned out to be crucial in the current economic and financial landscape. In the fiscal year ended June 2007, the fund returned 18.7%, net of fees and expenses. This is well ahead of both the fund’s RRO (5% plus the CPI) and above 85% of a peer group of public pension funds, compiled by the Independent Consultants Cooperative. Longer-term performance is equally impressive. In the 10 years to end June 2007, the fund returned an annualised 9.2%. Commodities have played a key role in that performance. Since inception in November 1998, commodities have returned 12.5%. When asked specifically about gold, Dahl highlighted that MOSERS had an indirect exposure via the GSCI. However, he added that interest in making a specific investment in gold had never been higher than at the moment.
An investment in commodities may not make sense in isolation: that would require demand and supply dynamics to be favourable. Even then, the investment may be deemed volatile. The true value of an investment in commodities lies in its use as a diversification tool: commodities will pay out in certain economic conditions, and not in others, and in doing so they can add balance to a portfolio by counteracting the behaviour of other assets. They are an excellent stabilisation tool, not a return driver.
MOSERS is a textbook example of how a plan sponsor can benefit from a strategic allocation to commodities. Their foresight means that commodities have provided diversification benefits and protection from unexpected spikes in inflation, both of which are crucial during the current market turmoil, and have helped MOSERS become one of the best performing funds in its peer group.
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