If at the start of the year you had spoken to a cross section of European institutional investors about whether or not they were interested in pushing some or more of their assets into commodities their answer would most likely have been a resounding ‘yes’.

At that time the Goldman Sachs Commodity Index (GSCI) had jumped up by 22 per cent on the previous year and by 45 per cent on the preceding two years; Hermes Pensions Management – the gatekeeper of the BT pension scheme – had moved £1bn (e1.46bn) of the fund’s £34bn (e49.7bn) assets into the sector; PGGM, the e74bn Dutch fund for healthcare and social workers, had announced returns of 26.9 per cent from its 5 per cent allocation to commodities; and FRR, the E28.1bn French pensions reserve fund, first hinted that it was going to make its opening move into the asset class.

But during the five days between Monday 15 May and Friday 19 May, gold fell $32 to $683 and US oil slipped two dollars to $69.50 a barrel, while on the Monday three-month copper dropped 9 per cent to a low of $7,700 a ton and aluminium shed some 6 per cent to $2,890 a ton. By the beginning of June the GSCI had also fallen 264 points after topping 7159 at the end of April.

Consequently the results of epn’s latest institutional investor survey, which polled 20 pension and insurance funds with some E95bn of assets under management, found that just three investors intend to increase their exposure to the asset class over the next six months although not one respondent said that it plans to reduce its allocation to the asset class.

“We have been observing the commodities market for a long time,” Eeva Grannenfelt, chief investment officer at the E5.3bn Pension Fennia in Finland, told epn. “However, each time we have had discussions about entering, we decide not to do so because of high prices and the fact that commodities are relatively volatile to market movements. It remains a question mark over which we have not yet made a final decision.”

Strategists, however, argue that commodity investing should not be looked at in terms of the recent market dive and that any decision to push money into the sector should be because of a strategic notion not a tactical one.

The cycle of supply and demand

“The demand for commodities will persist for three reasons,” says Philipp Vorndran, senior strategist for the asset management arm of Credit Suisse. “First, the migration from rural to urban areas in countries such as India and China will drive further demand; second, supply side limits look probable, particularly with energy and water; and thirdly, the trend of quasi re-nationalisation, as seen in Venezuela, Russia and now in Ecuador, Bolivia and most probably Peru, will result in rising raw material costs over the medium term, as this new risk demands that investments in production be recouped ever more rapidly.”

These factors, he adds, lead us to the conclusion that investors should be overweight commodities. Adding commodities to a portfolio will not only bring diversification and reduce risk it will also continue to make an important positive contribution to performance. “Globally, most institutional investors still have no or a very limited allocation to the sector but this will change with timber and copper futures [for example] being discussed in the same way we now talk about hedge funds or small cap Japanese equities.”

Solid demand and tight supply have unleashed a spike in commodities prices, which may suffer the occasional correction, but the longer-term trend in prices for basic materials such as copper and steel is upwards, agrees Jaap van der Geest, manager of ABN Amro Funds-Materials fund. “Global economic growth, particularly in emerging markets, should mean that demand continues to outstrip supply.”

He says that selling by financial investors such as hedge funds, which have been a driving force behind the recent sharp, seven-month rally, would allow industrial buyers of commodities to add to low inventories at cheaper prices. And that demand, in particular from budding economies such as China and India, should outpace supply for many years to come.

“Double-digit growth in China is requiring immense amounts of materials, for instance, to house rural workers who are increasingly taking up jobs in industrialised urban areas. Electricity needs mean that every year China is adding power generation capacity equal to that of Spain.

“Trends are on a similar scale in India, where, for example, infrastructure spending as a share of GDP is expected to double. In both countries, growing sections of the population are expected to reach a western-level standard of living in the next 10 years, feeding the appetite for consumer goods, which should further underpin demand for basic materials.”

But it is not only the emerging markets supporting raw material demand, argues Richard Saunders, senior manager, investment management, at Butterfield Bank. “The developed markets have also continued to grow strongly”. Mr Saunders cites the increase in the Institute of Supply Management composite index, which rose 2.1 points to 57.3 in April and beat expectations of 55.

“This indicates continued acceleration in US manufacturing activity. The majority of component indices recorded decent gains, with the exception of new orders, which slipped slightly but remained at a high level. In the long-term the materials sector should be supported by the positive influence of low global inflation, coupled with strong global growth, and reasonably tight supply conditions for many raw materials.

“In the short-term the recent correction seen in emerging market equities and the commodity markets indicate investors are becoming more risk averse, which is likely to lead to a period of higher volatility.” On materials, Mr Saunders says he remains overweight, with particular emphasis upon mining.

Decorrelation over performance

But for the bulk of pension fund investors – who are looking to invest over a time horizon of more than 15 years – returns from the asset class are not nearly as important as its decorrelation properties.

“The main draw is not performance but the de-correlation effect commodities have on the rest of the portfolio,” says Antoine de Salins, executive director of FRR. These effects are clearly documented from a statistical point of view, he adds, “and when you invest directly in a basket of commodities rather the underlying stocks of companies in that area, such as oil companies, you can really see that difference.

“Clearly when you invest in such assets you need to ask yourself whether the current level of prices – from the mid-term point of view – is sustainable. But we are a very long-term investor and as such we can capture all of the economic cycles.”

Nada Villermain-Lécolier, FRR’s head of asset manager selection, agrees: “The entry point for commodities is crucial. When you are thinking about investing in US large caps, for example, market timing is not so important but for commodities it can be.”

But unlike funds in the Netherlands and the UK, which recently saw Sainsbury’s announce that it intends to commit 5 per cent of its £3.8bn (e5.6bn) assets to commodities this summer, investors elsewhere are less convinced about the asset class.

Indeed, ABP, the E191bn pension fund for workers in the Dutch public and education sectors, began investing in commodities in 2001 with a 2.5 per cent allocation, while PME, the industry wide pension fund for the mechanical and electrical engineering industries, made a E700m commitment to commodities in December 2003. The fund now has 7 per cent of its assets allocated to the market.

“Over the past couple of years Dutch funds have discovered commodities as an asset class,” says Jitzes Noorman, financial markets research at Rabobank in the Netherlands. “Their interest is not so much tactical but is predominantly driven by the value that commodities can add to a portfolio, and to a lesser extent because of the inflation hedging potential of the asset class. This search for new asset classes has probably also intensified due to the new Financial Assessment Framework (the nFTK), which will be introduced at the start of 2007. The approaching FTK and the discussion to which it has already led has made funds more aware of their ALM policy and stimulated the level of sophistication needed for the asset class.”

But for Nordic funds, for example, that level of sophistication does not seem to exist yet. Nicolai Berg, investment head of Mercer Investment Consulting Nordic operations explains: “Hedge funds arrived first and funds have devoted more of their time understanding that asset class than commodities,” he says.

“Also, while investors do recognise that the diversification story for commodities is a strong one, they do not believe in the outperformance properties of the asset class and they are not prepared to invest based on diversification alone.”

Norwegian investors also “have a large exposure to oil via their own domestic stock market and, as the GSCI has a large bias to oil, they are put off commodities”. Elsewhere the relatively slow push into the asset class compared to the UK and the Netherlands is more to do with how investors want to spend their risk budget. They would rather spend their risk premiums diversifying into overseas equities and property than commodities right now.”

But pension and insurance funds in that region are making informed choices. “We have considered investing in commodities but so far have not taken any direct exposure,” says Tom Rathke chief investment officer at Vital, the E27.24bn Norwegian pension insurance company. “We have indirect exposure into the asset class, which we consider an important part of our portfolio, and direct commodity investments might become a part of our portfolio in the future.”

Gunnar Balsvik, president of Kåpan Pensioner, the SKr26bn (E2.78bn) fund for government employees, is not convinced. “We are not sure which way would be the best way to invest in commodities: directly or through equities that have underlying commodity exposure. It seems that the more interesting way to take commodity exposure is through the equity route, which involves less volatility and adds business performance on top of the commodity factor.”

Part of this article appeared in the Summer 2006 edition of our sister publication Nordic Region Pensions & Investments News

Printer friendly version

Email this article to a friend