Accessing volatile markets
So in the short term, there has been a slow down of growth but over the medium term this will turn around as companies increase inventories.
The supply side has also experienced difficulties, says Hermes’ Hemming, and this will place a strain on supplies of commodities ultimately driving up prices.
“In energy, there were outages in Libya and now Syria. International sanctions have also reduced supply from Iran and Syria, there are issues with North Sea supplies and labour unrest in Norway has disrupted production.”
Despite volatile markets – or perhaps because of them – there is considerable demand for commodity investment from institutions in Germany and the eurozone, says Pioneer’s Königbauer.
“They all want to get in the market but are not sure about the timing or which instruments to use,” he says.
If a scheme wants exposure to commodity prices, then they can always buy into the respective exchange traded fund (ETF) for most base metals and commodities, according to Damaskos.
“It all depends on appetite for risk, but we prefer to invest in companies that present to market, own the actual commodity in the ground, has strong cashflows, a strong balance sheet and strong management,” he says.
There are three critical things to determine when using this route, he says, and they are evaluation of proven reserves, the ability of the management to extract resources at a market efficient rate and to grow cashflow and that they have explorative developments as these will maintain the value of the company
“This can be far more volatile than both the markets and the underlying economy for example for 12 months,” admits Damaskos. This means schemes do not want to hold companies more volatile than the market, so they are oversold and become very cheap, says Damaskos. But the volatility is what pension funds want to escape and so many do not have the stomach for it.
He argues it is because pension funds are long-term investors they should be considering these assets, particularly in times of inflation or currency devaluation: “The things the developed world demands drives the economy of commodities,” Damaskos says. “Commodities remain attractive for long-term investors, for on a five to 10-year basis the demand will not grind to a halt.”
Reducing volatility and diversifying portfolios
Bluefin’s Kuller believes only a minor proportion of a fund’s assets should be invested in commodities: “The main purpose for commodity investments should be the potential for diversification and reduced overall portfolio volatility,” he says.
Larger pension funds with enough scale can access commodities by using specialist managers, or where in-house capabilities exist through direct investments, says Kuller, while small and mid-sized schemes should use diversified growth funds (DGFs) or potentially explore global tactical asset allocation funds.
Kuller says: “We believe that the right approach for these schemes is to let the DGF managers take a view on the relative performance of different commodities and markets as part of an overall diversified strategy.”
Hemming says it should be addressed on a case-by-case basis: “It is different for each pension fund. It is all about comfort levels with commodities and whether they can achieve what the scheme is trying to accomplish with the asset mix.”
Very few pension funds conduct commodities investment internally, but even those that do use both passive and active instruments. And though pooled and managed accounts are available, depending on the assets being sought, he says more pension funds are undertaking prime manager selection in the search for an active, skilled manager to add performance above the benchmark.
Still a bit risky
Datta agrees commodities can be a useful hedge, but says he does not recommend them currently. “From a strategic point of view, commodities offer an inflation hedge, but we are agnostic about that, because we think there are better ways of hedging against inflation,” he says.
Alternatives as a hedge include UK gilts, property or infrastructure, he says, and remains sceptical about the prices of energy and metals. In short, he thinks commodities are still a bit risky for most of his clients and adds: “Diversification alone is not a good enough reason for commodity investment.” Commodities have endured mixed fortunes of late but it seems with demand expected to last the next five to 10 years, a small allocation could reduce risk and diversify portfolios with a long-term investment horizon.
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