Institutional investors flooded into commodities last year as prices soared. Industry experts say the asset class' popularity isn't likely to wane in 2010, as Lynn Strongin Dodds reports
While industry pundits are unclear as to whether commodities will repeat 2009’s performance in 2010, they are certain that the asset class will remain a firm favourite with institutional investors. Diversification and exposure to the emerging markets growth story are likely to remain major drivers while the spectre of inflation will only add fuel to the demand.
According to a recent survey conducted by Barclays Capital at its annual US commodities investor conference, 2010 could beat the investment record of 2009, which reaped inflows of US$60bn taking the sector’s assets under management to $250bn. About 60% of the 300 attendees canvassed said they had increased their commodity exposure over the past 12 months while 63% indicated they plan to raise their commodity exposure over the next three years.
The recent decade was one of the most significant boom and bust cycles in commodity indexing
On an asset allocation level, Barclay’s Capital commodities analyst Amrita Sen said: “I think 5% to 10% will continue to be the average asset allocation for now although there are those in our survey who are looking to increase it above 10%. What we are seeing is that while commodities are still seen as an alternative asset class, they are becoming one of the most popular in that space. While diversification is important our survey showed that the main reason behind commodity investment was to generate absolute returns.”
Investors were rewarded last year as the bulk of commodities produced a healthy crop of returns, rebounding sharply from 2008’s lows but closing well below records set before the financial crisis began in 2008. For example, the Dow Jones-UBS Commodity Index reported a 19% hike to 117.24 in 2009, about 41% off its peak in 2008.
Base metals led the way in 2009 on the back of the continued urbanisation of India and particularly China. Copper, which has several industrial uses, more than doubled, soaring 139%. It ended the year at $3.3275 per pound but still 18% shy of record prices hit in 2008. Lead, on the other hand, which is used in car batteries, also more than doubled, to $2,416 a metric tonne, followed by zinc, up 125%, and aluminium, up 50%.
Precious metals might have turned in smaller gains but they stole the spotlight, especially gold, which jumped 24% to $1,095.20 per troy ounce at Comex, the metals division of CME Group. It set 27 exchange records during 2009 amid strong demand from funds and individual investors seeking a safe haven against inflation, a weak dollar and economic uncertainty. Silver in the meantime surged 49% to $16.822 per troy ounce.
It is too early to predict which will be the best performing sectors and whether last year’s winners will repeat their success. As ETF Securities head of research and investment strategy Nicholas Brooks said: “Most of the commodities have rebounded sharply from their low levels in 2008 but 2010 is hard to call. Expectations are running high and there could be scope for disappointment as there is already a lot of good news factored into the market. I think what we could see is more range and choppy trading in the next few months.”
Axa Investment Managers portfolio manager analyst Oliver Eugene agreed, adding: “Most commodities produced positive returns after a poor 2008. They fell later than the most risky assets but recovered after the first quarter for 2009. I do not, though, expect to see the same price increases this year as last year. In general, prices are high enough to justify new investments by producers and investors will have to be more specific in their choices.”
Industry participants also stress that institutional investors have to adopt a long-term view when investing in commodities. As Standard & Poor’s director of commodity indexing Michael McGlone said: “The recent decade was one of the most significant boom and bust cycles in commodity indexing with 2008 being a one-off historical aberration. Looking over the last 10 years though, the S&P GSCI posted a cumulative total return of 63.69% led by a 265.84% increase in the S&P GSCI Precious Metals Index. The correlation with the S&P during that period was about 0.2.”
In addition, Hermes Fund Managers head of commodities Colin O’Shea believed that the advantages of commodity investing have not changed. The risk adjusted returns of having commodities in a portfolio is more beneficial than the traditional mix of equities, bonds and property. They also add diversification although investors will not gain those benefits during demand led economic shocks because commodities tend to perform poorly when GDP falls. They perform best during periods of high inflation and growth.
Views are mixed though as to whether inflation will be a major factor this year. State Street Global Advisors’ vice president and portfolio manager with the multi-asset solutions group Dan Peirce said: “It is hard to see inflation picking up dramatically this year when home ownership has fallen sharply and unemployment is still high. I think it is a valid long-term concern but at the moment demand from emerging markets countries for basic metals, foods and energy is likely to be main drivers of growth.”
Barings’ manager of the global resources fund, Jonathan Blake, said: “There is no question that the monetary and fiscal stimulus policies over the past 18 months will feed through to inflation over the long term. In the short term though, commodities will benefit from the underpinning of emerging market growth and the recovery of the developed world.”
Risk and growth
In terms of investing, pension funds have to carefully assess their own requirements, according to ING Investment Management Europe’s head of strategic advice, implemented client solutions Derick Le Roux. He noted: “Commodities is a high volatility asset class and the inclusion of it in a pension fund’s asset portfolio should be determined by the risk budget available – which means that if the risk budget allows it and a favourable growth cycle is anticipated, it justifies an exposure to commodities. The way that pension funds look at commodities depends on the regulatory environment they are operating in, their sponsors and participants. If a pension fund does not have a strong solvency ratio or it is in danger, then I would not recommend investing in commodities.”
Broadly speaking, there are three main ways to gain access to commodities – equities, active or passive management. According to the Barclays survey, structured commodity products and long-short index strategies showed the largest gains in interest compared to 2008 while demand declined for long-only index investments, which buy futures in hopes of price appreciation. Looking ahead, 40% of respondents said they will look at third-party active management.
Sen said: “We have two categories of investors. The first is the more traditional group who wants exposure through an index. There has also been the emergence of the sophisticated investor who is interested in more active management. They are not just looking at hedge funds but long/short indices and more enhanced products.”
While there has been interest in buying physical commodities such as oil, timber or cattle directly, institutions need deep pockets for storage facilities as well as management of the asset. Traditionally, indices such as the S&P GSCI and DJ-UBS account for 80% to 85% of all commodity investment. They are constructed by purchasing front-month futures contracts that are then rolled over before maturity, typically selling one contract and buying another every month. One of the main problems over the past couple of years is that many markets have been in contango which is when future prices are significantly above the spot market which negatively affects performance.
To combat this, providers have rolled out so called enhanced exchange indices which try to sidestep the problem of contango by using different roll periods. For example, the S&P GSCI crude oil enhanced chooses between the next month and six-month contracts when rolling its futures market positions, depending on the steepness of the oil forward curve. PowerShares DB Commodity Index ETF on the other hand, chooses the most favourable contract over the next 13 months and then rolls into that while the UBS Constant Maturity Commodity Index (CMCI) blends exposure over many months and years, trying to provide a more balanced and even exposure to the commodity space.
BlackRock’s multi-asset portfolio strategies group managing director Ewen Cameron Watt said: “The truth is that investing in commodities can be difficult because of the roll yields. It has been made easier with ETFs and swaps but investors tend to find it hard to get the valuations correct. Active management, though, can also be challenging. Every manager has their own model and they can be unpredictable. Also, there are not that many long-only active managers with long established track records.”
Investing in equities also divided opinion. Blake believed there are significant opportunities in companies involved in energy, mining and metals sector as well as agricultural fertilisers. They are attractive because they provide different sources of return such as capital value and dividend yield versus just the reliance on the commodity price.”
Schroders’ commodities product manager Christopher Wyke, said: “Although gaining exposure through equities has been popular it is sub-optimal as it involves corporate and equity market risk and the investor may not get the benefits of diversification. For example, many gold miners had hedged future production thus causing their share price to underperform the gold price. As for index investing, indices have underperformed spot prices due to contango and other problems.”
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