If, at the start of the year, you had spoken to a cross section of Nordic and 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 (€1.45bn) of the fund’s £34bn 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 this year, 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 7,159 at the end of April.

Consequently, the results of nrpn’s latest institutional investor survey, which polled 12 pension and insurance funds with some €92.6bn of assets under management, found that just one investor intends to increase it 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 €5.3bn Pension Fennia in Finland, told nrpn. “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.”

Budding economies fuel growth

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.”

Developed markets support raw 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.

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 decorrelation effect commodities have on the rest of the portfolio,” Antoine de Salins, executive director of FRR, told nrpn. These effects are clearly documented from a statistical point of view, he adds. “And when you invest directly in a basket of commodities rather than the underlying stocks of companies in that area, such as oil companies, you can really see that difference.

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Hermes targets beta over beating the benchmark

Hermes Pensions Management – the gatekeeper of the £34bn (€49.5bn) BT pension scheme – decided against an active approach to its £1bn investment to commodities. Instead the £1bn investment, the largest single allocation by any institutional investor in the UK, will track the 24 different commodities held within the GSCI Light Index. James Walsh, Hermes’ head of strategy and alternatives, believes it is too difficult a market for active managers to add value.

‘The problem with active managers is the pressure they put themselves under in order to beat the benchmark,” he says. “It is great if they do beat the market but invariably they don’t when it comes to commodities and that can take away from the beta. The key thing is to get the beta.

” The push, which has been made by way of an open-ended Guernsey-registered and listed fund, represents 3 per cent of BT’s total assets and follows on from the fund’s recent forays or increased allocations to hedge funds, private equity and PFI.

“Three per cent is the minimum size we could invest that would actually make a difference to the BT fund,” continues Mr Walsh. “The Dutch funds, for example, started small and built up from there but, for us, it was all about making a worthwhile initial investment.”

Hermes built up in-house commodities expertise in order to assess the impact of the investment over the longer term, and how it would fit in with a portfolio of other investments. Their findings, supported by research from Yale School of Management, showed that an investment in commodities, along with other alternative investments, improves overall returns and significantly reduces volatility.

“The research we did suggests that every and any scheme should have a 2 to 5 per cent exposure to commodities – in fact, the research showed that the more a particular fund allocates to equities, the more it would benefit from an exposure to commodities.”

Compared to the regular GSCI index, the GSCI Light has a modified weighting to the overall energy component (oil and gas), which is based more on the historic weight of the energy sector. “This decision was made to reflect current concerns around the recent run up of energy prices and their aggregate weighted effect on the index,” says Mr Walsh. “The two-year rally in energy prices has meant that oil and gas have become too influential in the standard index. We wanted to eliminate that short-term spike.”

Over the last 50 years, commodities and equities have provided similar real returns in excess of 5 per cent a year (compared to bonds at approximately 1.5 per cent). “However, the correlation of the performance, especially over the longer term, has been quite different – with commodities stronger in inflationary periods and at moments when equities (and bonds) come under severe pressure,” adds Mr Walsh. BT’s allocation to the asset class was made before the recent meltdown in commodity prices, which saw Gold fall $32 to $683 and US oil slip two dollars to $69.50 a barrel during the five days between Monday 15 May and Friday 19 May, but Mr Walsh is not worried. “You buy commodities to get volatility but volatility in the commodities arena spikes up more than it spikes down.

“Our entry into the asset class had nothing to do with allocating tactically but I would suggest that investors interested in gaining an exposure to commodities should take advice about market timing.”
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“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 assets to commodities this summer, investors in the Nordic region are less convinced about the asset class.

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Investors staying put

The results of nrpn’s latest quarterly investment survey show that out of the 12 pension and insurance funds polled one investor intends to increase its exposure to commodities over the next six months with seven indicating that they will keep their holdings at the same level. Not one said that they intend to reduce their exposure and four said that they did not have any commodities exposure at all.

However, in our previous survey, which took place in March this year, 30 per cent of respondents said that they intended to increase their commodities holdings over the following six months and 70 per cent of funds said that intended to keep their holdings at the same level. “We are slightly cautious to enter the commodities market and adopt it in our portfolio as a meaningful asset class,” says Mikko Koivusalo, director of investments at Varma, the €24.6bn mutual pension insurance firm. “Recently the commodities market has been very successful. This means that it might also be more risky. Despite this we do view commodities as an interesting investment tool and will continue to observe it in the future.” Indeed, ABP, the €191bn sectoral pension fund for workers in the 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 Metalektro, the mechanical and electrical engineering industries, made a €700m commitment to commodities in December 2003. The fund now has 7 per cent of its assets allocated to the market.

Commodities add value

“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 nFTK 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.”

For Nordic funds 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”. 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 Nordic pension and insurance funds 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 €27.24bn 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."

For Gunnar Balsvik, president of Kåpan Pensioner, the SKr26bn (€2.78bn) fund for government employees, a direct exposure to commodities looks unlikely. “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.”