Peter Carvill looks at the shifting commodities landscape

In recent decades, investment by pension funds into commodities has been seen as something approaching what may be described as a way to counter-balance the risks from traditional stocks and bonds. As The Role of Commodities in an Institutional Portfolio states: “The case for commodities is based largely on their historical tendency to offer returns that exhibit a low correlation with those of stock and bond market indices. Although commodities may be volatile, their low correlation with traditional investments can result in a significant diversification benefit.”

Others have made similar assertions. Speaking at Harvard Law School’s tenth Annual Pensions And Capital Stewardship Conference last year, University of Massachusetts Amherst professor of finance Thomas Schneeweis said: “While it is impossible in a short synopsis to convey all of the benefits of commodity investments, commodity investments have been shown to provide additional return enhancement as well as risk reduction opportunities to traditional and altern-ative investments.”

The real benefit of commodities, says S&P Dow Jones Indices head of commodities indices Jodie Gunzberg, is that their pattern of returns has been different from stocks and bonds. Adds Gunzberg: “In only four years since 1970 have the S&P 500 and S&P GSCI fallen together, which is a diversification characteristic that has led to capital preservation for plans by increasing returns while reducing risk over the long run. Also, since commodity indices are largely made up of the same food and energy as in the CPI, by construction they have provided inflation protection, and one dollar’s worth of investment has provided more than one dollar’s worth of inflation protection.”

That, however, has recently changed with Canadian Investment Review reporting that “investors are beginning to question the link between commodities and hedging—today, many are realising the performance of commodities has become more tied to equities, cancelling out that side of the hedge.
Plus, China’s slowdown has made the sector more vulnerable. All this means is, commodities are more volatile right now—and that is scaring off some funds.”

That ill wind has chilled parts of the US’s pension landscape, with The Wall Street Journal reporting in February on how two of the US’s major pension funds had slashed their investments in commodities. “Calpers, the nation’s largest pension fund, pulled out 55 per cent of its holdings in commodities indexes in October, after losing about 8 per cent annually over five years, according to the fund’s most recent financial statement,” said the report. “That left $1.5 billion of Calpers’s assets in commodities indexes, 0.6 per cent of the fund’s total.” The second fund, the report added later, referred to ‘volatility of commodity investments’ when it decided to re-allocate $800 million of its $3.5 billion portfolio to better protect the fund from inflation.

The Wall Street Journal concluded: “Pension funds and other institutions are retreating from popular investments linked to commodities after finding they did little to protect their portfolios against inflation risk and the unpredictable returns of stocks.”

First Quadrant’s director of global macro research Jesse Davis says the recent shifts across investment in commodities has not been down to the make-up of the product but the manner of how funds were investing in this space. Diversification, he asserts, is key to success in this area. “The problem that has caused some funds to pull back from commodities is the way they invested. The traditional benchmarks are highly overweight and highly concentrated into just one sector, which is energy. Within the most common benchmarks, 70 per cent and 95 per cent of the risk there comes from just energy. What that means is that although you think you are diversifying when you allocate into commodities, if you allocated into one of these benchmarks, you are adding just one more asset into your portfolio and over-allocating to it.”

“First things first,” says Neuberger Berman quantitative analyst Hakan Kaya, “commodities have never been ‘safe’ and never will be. No matter how one measures risk, commodities will be on the risky side of the spectrum when compared to fixed income, and certain equity investments. As a matter of fact, even gold, the so perceived ‘safe’ heaven, has exhibited long term volatilities that are comparable to large cap stocks.”

The landscape, then, for commodities investment is far from secure. The past month, says Davis, has been a bad one for the sector although that has not led to either cocoa or natural gas being down. In fact, those commodities are up by 10 and 20 per cent respectively. On the other hand, however, precious metals such as gold and silver have been down by as much as 10 per cent. This, says Davis, is why a diversified approach needs to be taken in investment in this area.

Others, including Blackrock Alternative Advisors’ managing director Ed Rzeszowski, agree. “What we’re seeing this year,” he says, “is less of commodities moving lock, stock, and barrel. In fact, we’re seeing more of an idiosyncratic approach at the commodities level. As to what will move – and what will make it move at any point in time – we prefer a broader basket which will be allocated to the agriculture, energy, and metal sectors. That approach is more robust than just buying natural gas or crude oil ETFs, or just one of the agricultural ETFs. It’s diversification but in a more active format.”

While all agree that diversification is the right approach, the subject of weighting is more problematic and open to interpretation. In truth, says Kaya, the answer to that is ‘situation- and belief-specific’.

“For example,” he says, “does the manager expect an increase in inflation? If so I believe commodities deserve a larger portion. If the portfolio has a lot of illiquid real investments, and the manager is worried about meeting short term liabilities, then again, it is probably more beneficial if a larger portion of this real bucket is allocated to commodities," Kaya says.

"One piece of advice I would offer here is that managers should take utmost care when using historical data to assess the risk/return profile of commodities. Especially, extrapolating last five years data to future will potentially be a good example of driving a car by looking at the rear view mirror. I believe going forward we will revert to the long term, unconditional measures of risk and dependencies. Basically, the high volatility, high correlation regime of the past will not necessarily continue.”

Rzeszowski picks up this thread: “If one is looking to a potential hedge against inflation, to take advantage of emerging markets market growth, or diversification in the form of lower correlation, they want to go down the route of the more traditional commodities index. We believe in a more active approach. There are a lot more people who haven’t been satisfied with commodities index exposure so one needs a better solution in order to extract returns in using a more active approach but being more liquid.”

So with diversification in mind, how should funds be investing? Neuberger Berman is against benchmarks in this space. Says Kaya: “We don’t believe there can be a benchmark in commodities. The current benchmarks are active strategies based on production weighting. At the very essence, a manager should ask why they would like to get exposure to a commodity that is produced the most? What’s the value in a commodity if it is produced more and is more relative to those that do not produce and as such are scarce.”

Gunzberg offers a broader approach, one that advises plans to look at their own risk tolerance for illiquidity, transparency, size, and fees, and use this alongside potential premiums to make their choice.

That, plus judgement, should be enough; as the demographics of the world’s economy continue to shift, there can be few – if any – safe or even safer bets in investment.

Peter Carvill is a freelance journalist

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