Commodity debate: Finding the diamonds in the dust

Commodities debate participants

RB, Watson Wyatt So Frans, what issues do you consider when investing in commodities?

FdW, PGGM We invest in commodities for diversification purposes, to bring down volatility without sacrificing return. Commodities have done very well in our portfolio since 2000, although the scope has changed, especially with the current contango and lack of backwardation. We keep an eye on the lack of backwardation, but we’re not unduly worried. The bigger picture is still diversification. We want commodities as a strategic position, to hedge against unexpected events, as well as for return. However, our allocation of 5% is not enough to hedge us against the risk of inflation. It would have to be much higher for that but there are better vehicles available to get inflation protection.

RB, Watson Wyatt Paul, who invests in your funds and what are they looking for?

PT, Touradji We encourage people to think of our active products as pure alpha vehicles, as opposed to an inflation hedge. Until three years ago, there had been either sideways or down markets in commodities. In the last three years there’s been heightened interest from the institutional community, primarily from a beta perspective but increasingly for alpha. Whether it’s a reflection of the maturation of the asset or of this disappointing contango in the market, it’s created a problem for investors, and a combination of the two is leading people to move away from traditional beta investment. There’s been a lot of angst, both in the press and the markets, about this negative roll yield turning away all the traditional commodity investors. That’s patently silly. The long-only investors came in primarily for the diversification benefit. Rather than a rush for the exits, we’ve seen a rush to figure out how to counter the weight of money that’s causing the nearby rolls to the negative roll. We’ve seen pick-up in work on how to do better than traditional investors.

RB, Watson Wyatt Has that proved beneficial?

PT, Touradji Our job is to make money through any environment. When that environment changes, so must our strategies. We have been investing more heavily in relative value rather than directional, adapting to the heightened volatility. If the volatility subsides, we’ll invest more directionally again. We’ve always seen opportunities in the commodity markets. It’s a challenge to capture those opportunities, but that’s our job.

BG, Pimco Investing in commodities is a good idea, primarily for diversification. We deal with institutional investors, as well as high-net-worth and family-office investors. Investor numbers are growing and those already in the markets are staying in. The exception is the retail investor who tends to chase returns. The negative returns of the GSCI, or the flat returns of the Dow Jones AIG commodity index in 2006, caused some retail investors to leave.

PD, Commerzbank Supply continues to play catch-up with demand, which suggests that the bull run still has some way to run. A key element in our client base are German corporates, which are particularly interested in oil prices, but which also have a keen interest in base metals prices. Our investor client base has a wider interest, but what is common to both is a particular interest in hedging strategies given the huge rise in uncertainty which has surrounded commodities over the last year or so. In our view, investing in commodities is still a good idea, because markets are tight, demand in Europe and the US remains solid, and Asia is the big swing factor which will continue to drive markets higher. Unless you think there’s going to be a sharp correction on fundamental grounds, you want to be long commodities.

SW, Diapason Commodities have been through a cyclical correction, and we have had under-average returns over the past 12 months for the asset class. Every investor wanted to a cyclical correction before investing, and now they’re getting it. It is an opportunity. We’ve seen a slowdown in US activity, and many of the cyclical commodities have been under pressure, especially oil. But on the bigger picture supply/demand/inventories imbalances remain, there’s a shift of power from west to east implying more infrastructure developments. There’s a shift of return from paper asset to tangible asset. There’s a shift in environment from disinflation to more inflation. All that is favourable for commodity prices.

BM, Morgan Stanley An issue is the persistence and steepening of contango; it has made the internal sales job for pension funds trickier. An environment whereby they could go in with a zero forecast for spot returns and still have a positive return due to the backwardation meant the argument was easier to make. In the contango environment you need a positive spot price forecast to justify investing, so some are finding it trickier. But on the flip side geopolitical risk continues to increase, making the event risk hedging case for commodities greater. So the total-return forecast is weighed down by this contango but the diversification aspect is strengthened by the fact that you need a geopolitical hedge to the tension in the Middle East. Regarding flows, the retail sector in Europe has woken up to commodities. A lot of jurisdictions in Europe didn’t have access to this asset class before, and now they do, through structured products or funds. A lot of them are grabbing this opportunity.

RB, Watson Wyatt It’s interesting that with a negative roll return and a question-mark over spot prices, to invest you have to place an emphasis on the hedging capabilities, the left tail risks and the diversification issues for commodities to look a good idea. Institutional investors may ask whether there are alternatives with similar properties. What are your observations?

PG, SwissLife Asset Management We can see the importance of diversification and the potential inflation hedge but it’s also about return. Are commodities a strategic asset? If I invest in them, will I make money? We concluded some years ago that commodities investing was meaningful in terms of strategic asset allocation. But as an insurance life company we are constrained by regulation on the assets we put on alternative investments, and that means that if we include commodities on top of hedge funds and private equity, we have to be careful about the total investments we have and our expectations in terms of benefits, returns and diversification. Regulation drives the way we invest, and has driven us to choose active strategies rather than beta exposure. For getting an inflation hedge, we prefer direct real estate rather than commodities on a beta exposure because direct real estate investment is fully regulated for an insurance life company, and playing an alpha portfolio with commodities.

RB, Watson Wyatt So strategically commodities may still make sense. There are question marks over return prospects but exposure is a key issue. What about the flow of institutional money into commodities. Are there speculative bubbles?

BM, Morgan Stanley As an index provider we cover all 24 commodities and all five sectors. Some sectors overshoot more than others, and some lose some grounding with the fundamentals behind them. But it’s not fair to say that commodities as a whole suffer from that, because the situation is complex. For instance, the astronomical price appreciation of base metals suggests that versus historical measures, metals have overshot. But it’s complex, as how can you value metals using historical guides if you’re in a position of days inventory for the first time? In this uncharted territory, what one person may see as an overshoot or bubble another may not.

The commodity picture also keeps changing. The demand for ethanol in the next two or three years is changing the landscape of corn and agricultural commodities. They’re all linked so it’s difficult to establish whether the price rise is a runaway from fundamentals, because we’ve seen an injection of new demand that changes the landscape versus what is reflected in historical data. So history not really a good guide to judge this bubble question.

Regarding institutional inflows, they are far more cautious as to how they allocate to commodities now. The contango in the market as well as a multitude of indices jumping up has complicated the task for institutional investors that want diversification but still want to capture the latest idea or sophistication when it comes to investing. They’re still coming in, but not into the plain vanilla indices as they used to.

PD, Commerzbank If you overlaid the price moves in commodities against movements in stock prices in the late 1990s, you’d see similar patterns. On the surface that might look a dangerously big price move – some might even say it looks like a bubble. But there are other factors. There’s risk premium factored into prices, which isn’t speculative because in many cases it’s justified. Over the past five years we have seen a massive increase in global liquidity as a consequence of the actions of central banks. That has to go somewhere. Initially, it went into bonds, then equities ramped up, and over the last 18 months investors have put funds into commodities. If commodities are in a bubble phase, then they will go pop at some stage, but why would investors take money out of commodities? The funds investing for diversification are not speculators. They see commodities as an alternative asset class. Admittedly, you do see some speculative activity, suggesting that some investors may get hurt if prices turn around. But our traders will tell you that we are booking as many short trades as long trades. That suggests that there are plenty of investors out there covering themselves in the event of a price correction and also suggests that trading desks are going to make money either way.

BG, Pimco One impact of the investors, be they index investors or hedge funds, is that they might be impacting the pattern of returns by contributing to contango, by reducing the risk premium that has been there. But is there a speculative bubble? As the manager of over $14 billion of long-only investment, we do not own, consume or store one barrel of oil, one bushel of corn or any other commodity. We are not adding to the demand for the physical commodity. Financial investors are not driving up the price in the cash markets. Futures tend to converge to the cash price more than cash prices converge to the futures price. There are two requirements for a speculative bubble: constraint on supply so that a flood of money will drive up price, and losing any way of determining the asset’s intrinsic value. Neither of those hold true for commodity futures. There is no constraint on the supply of commodity futures contracts. As far as losing any measure of intrinsic value, we have large liquid cash markets where supply and demand and consumption serve as a check on what otherwise could be a runaway price in the futures markets. There is not a speculative bubble.

SW, Diapason To have a bubble you need excess, and index commodity prices are around their four-year average. You need disproportionate money flow, excessive leverage in the asset class and for the public to be massively involved. That might be the case for private equity but we are still far off as far as commodities are concerned. Many commodities have been correcting or struggling for 12 months. I don’t see bubble conditions except maybe for nickel. A lot of commodities are at rock bottom. Oil is down, many metals are flat, cotton is as cheap as it’s ever been in real terms and in nominal terms it’s just off the levels where it was in 1948 or 1919. Lumber & sugar just fell 50%. Coffee is cheap. Wheat is cheap. Gold has not broken yet its 1980 nominal high and production is now falling. When Nasdaq reached the bubble stage it was up 15 times from its low and three times over the previous 18 months.

PT, Touradji In real terms many commodities are sitting closer to their lows than unprecedented high prices but measured against their cost of production, on a long-term historical graph, many may seem as if they’re defying gravity. Measured against cost of production they seem closer to the mean. Take crude oil. At $70 it is in a different stratosphere than the decades-long $10 to $25 range. However, the marginal cost of production for crude oil was around the low teens. Today, we’re getting a marginal barrel from Canadian Oil Sands, which has a marginal cost of around $45 to $50. So $70, compared with $45 to $50, and that’s not even including inflation adjustment. Cotton is another example. Even in metals, there’s been a significant increase in the cost of production. Five-year forward aluminium sits close to its cost of production, which is extraordinary. Our style of investing has always been about looking at the supply and demand fundamentals and trying to figure out when there’s a disequilibrium, or a relative value spread. Nothing has changed that makes that wrong but we are going through an extraordinary period of infrastructure development in China, Brazil, Russia, India, the Middle East, South Africa and Australia. You should never say "it’s different this time". It’s different from the economic model we were taught in the 1970s, 1980s and 1990s, but it is analogous to the 1950s and 1960s when South Korea and Japan were developing, or perhaps the 1880s when it was the US. In those periods markets had a hard time adjusting to the demand but it wasn’t a bubble. It was infrastructure-led growth. The difference this time is that China makes it a large base to contend with: to industrialize a billion people consumes a lot more barrels and bushels and raw materials.

What is different this time, however, is that the world is dealing commodities as an asset class, and that has attracted a larger sum of institutional money and speculative money than in previous decades. There’s greater demand for liquidity in the system.

SW, Diapason In a bear market, prices tend to trade at or below cost of production because the market function is to deincentivize producers. In a bull market, the market function is to incentivize the producer and create profitability for them, push them to invest, so prices will trade above the cost of production. Many commodities have plenty of room to go far above cost of production from current levels. We are still not yet at the over-investment phase.

PG, SwissLife Asset Management We could measure the bubble by the number of phone calls we had regarding commodities. Up to spring 2006 it was probably one every week, and now it’s one every quarter. Until 12 months ago, there was some speculation but today it’s normal. We see hedge funds as a sane instrument, whatever the asset class. They take contrarian views, so they help on average reduce any potential bubbles, aberrations or financial distortions, and they should profit from that.

FdW, PGGM You have to differentiate between an institutional investor and a hedge fund. Institutions are usually in it for the long term. The higher the oil prices, the higher the risk of an economic drawdown when the price jumps even further, and subsequently the less likelihood there is of us getting out. The speculative bubble is less likely to pop. With hedge funds, you see the effect in the spreads, especially if you see the monthly rolling in the index. You see the effect of hedge funds pre-rolling it or post-rolling it, but not necessarily in one direction. We don’t think it’s a speculative bubble either.

RB, Watson Wyatt Are institutional investors and hedge funds adversarial or complementary in this area?

BM, Morgan Stanley Institutional investors make index investments which may stretch across 35 commodities that roll on specific dates. It seems a predictable investment which could lead to plentiful opportunities for other active participants to exploit. But the players who understand the market know there are plentiful opportunities without trying to capitalize on these mechanics; opportunities with greater IRs in terms of what you could expect from your strategic active position or tactical active position. Sceptics like to portray institutional investors as being exploited by hedge funds but that’s not the case. Institutional investors aren’t lambs to the slaughter of hedge funds. They’ve got bigger fish to fry.

PT, Touradji As we’re both a passive and an active investor, we have both kinds of player within the same firm. I agree with misgivings about hedge funds taking advantage of passive money. I wish it were that easy. The main issue in commodities is that there is too large a weight of money to all follow the same passive strategy. In the traditional Goldman Sachs Commodity Index structure, we were all in the same contracts. We all rolled from the first to the second month on the same dates. There was nothing wrong in that index construction but as we approached $100 billion to $120 billion of activity doing the same thing, the weight of money made that sub-optimal. The same would have happened in fixed income or equities.

So institutional investors hived off into different strategies, which corrected the problem for a while but as soon as the weight of money starts to employ any simplistic mechanical strategy, that’s going to become sub-optimal. It doesn’t mean that investing in commodities as an asset class is bad. It means that the task of remaining in the optimal instrument is tougher with the greater weight of money.

SW, Diapason There is no all-season investment strategy, and depending on the phase of the market some strategies will do better than others. It’s the same with equities or bonds. In a trending market, it’s very hard for the active manager to perform as well as the index. When the index is a trading range or down phases, there could be other strategies that the active players can implement to take advantage of the range-bound prices. But overtime, very few managers tend to beat indices in up trends. Boggle and S&P have documented it.

RB, Watson Wyatt A number of institutions that started in commodities on a passive basis have moved towards more active strategies. How do you get exposure, what sort of strategies are appropriate and how do you enhance returns?

FdW, PGGM PGGM started using commodities as a diversifier. We were looking for a passive investment because we wanted to be long only in energy. You need specific commodity knowledge to trade single commodities from a pure alpha angle and it is therefore difficult to do in house. We traded active commodities ourselves but after three years we decided against it, because you need dedicated traders to capture alpha. We have separated our beta portfolio from our alpha portfolio and outsourced our pure alpha portfolio.

RB, Watson Wyatt Do you still have a strategic exposure to energy in your beta component?

FdW, PGGM We increased that in 2003 and even higher in 2005, so we have roughly an 80% energy exposure. We recognized that the energy component was the best diversifier among our assets. We use enhanced indices within our beta portfolio, to get efficient beta, and that’s a nice way to make good on the costs that you have to pay on the swaps as well as to avoid the footprint of the index. The higher energy weighting is not done from an alpha point of view. The long-only approach there is not an efficient way of getting alpha, because you don’t want to deviate from the fact that you’re in there because of diversification. Energy is not necessarily the best way to get alpha from the whole range of commodities.

RB, Watson Wyatt You’ve been a GSCI-heavy participant rather than taking a more diversified approach by using different benchmarks?

FdW, PGGM Correct, because we don’t see it as a stand-alone investment. The Dow Jones is a better-diversified index, but we are looking for that heavy energy component, because that lowers the overall risk.

PG, SwissLife Asset Management Choosing the right index is crucial because any index is a portfolio. The way it’s constructed should give you an investment process you are comfortable with. Any index should be transparent, otherwise you cannot use it as a benchmark. Whether you use swaps or enhanced-index strategies, active approaches or exchange-traded funds, you face the same issues in any asset class. It depends on your risk appetite, on the asset allocation you want, and how much risk you want to take on top of your strategic asset allocation and on top of your benchmark. If you want to be active, you need to understand what that means. Choosing between passive and active is very important in any asset allocation. We decided to have only very active alpha strategies in the commodity space. We have a portfolio based on hedge funds where we have zero correlation with equities, bonds and commodity indices. We invest with managers who play with commodities but we are not investing directly in commodities. We have the alpha from it and no beta at all.

BM, Morgan Stanley But isn’t the risk of the active approach the non-transparency? You don’t necessarily know that you have commodity exposure when you may need it. The alpha player may have a position in a long-short or relative-value strategy which doesn’t give you the geopolitical hedge or the inflation hedge. Investors who have the opportunity of going active as well as passive often have this risk of pursuing active but not having transparency. They think they’re in commodities and still have that desired beta but in reality they may not have commodity beta.

PG, SwissLife Asset Management You should get some risk premium somewhere but you shouldn’t get any beta, at least on average a zero beta. You’re not very concerned what the market does. We are constrained by the regulator to 10% of total assets in alternative investments, so our problem is how to spend this risk allocation efficiently. We have hedge funds, private equity. We assumed that we want to put commodity on top of that. Is it worth adding on commodity beta exposure somewhere, which may compete with other economic factors that may influence real estate the same way, for example? Real estate is probably the only hard asset we are allowed to hold in our portfolio. Naturally, we would love the decorrelation effect versus bonds and equities but we were facing a choice. By going into beta exposure in commodities we may overweight some economic factors that may influence other asset classes.

BG, Pimco There’s a range of strategies in between totally passive index exposure and totally active commodity trading and hedge funds exposure. From totally passive it moves to structurally active: enhanced index strategies, then to active over- and underweights, and then to totally active. When you’re in passive, the asset class you have exposure to is commodities and that has the inherent diversification. By the time you get to totally active, the asset class you have exposure to is not commodities, it is brain power. If that brain power is good you will have good returns, but the drivers of your returns are different in the total active from those in the total passive. The structural alpha in between, again, can be implemented in a way that is alpha versus the passive benchmark versus the passive asset class, so you still get the diversification and secondary inflation-hedging benefits of an index with structural alpha on top of it. That stops short of moving over to brain power.

Efficient market?

RB, Watson Wyatt Do you think of commodities markets as efficient or inefficient compared with other asset classes? Are there more opportunities in commodities?

BG, Pimco There are more opportunities, even though the markets are increasingly efficient. In addition to Keynesian normal backwardation there are other risk premia embedded in a range of structural strategies that can create added value on top of the pure beta of the passive index.

PD, Commerzbank The products you’re dealing with depend upon the clients you have. We have, for example, a big German corporate client base that generally has an interest in passive products. But our institutional clients are very interested in more active products. We’ve found great value in structured products, which offer varying degrees of protection, depending on how much the client is willing to pay. One of the problems the business will face in future is that it will become less profitable as more competition enters the market. This is a natural progression as investment markets mature, and is a key factor which raises efficiency. The use of indices as a benchmark for commodity trading obviously enhances the efficiency of commodity trading, since they’re transparent and they’re easy to use for those of us new to the business. But we’ll no doubt find the structure of these indices changes as investors become more sophisticated. People base much of their analysis on the GSCI. I’m concerned that, in comparison with other indices, it overweights oil, which, from an economic perspective, seems unjustified – especially as there is increasing interest in trading other commodities. Thus, as investors realize there is more to commodities than oil – and many of them are there already – new indices will likely be established as industry benchmarks which assign a lower weight to oil. However, in practice this is less important than you might think, because most of our clients buy sectoral indices and choose their own weights for the sectors.

SW, Diapason We have always asked, "What is the beta for the asset class? What should it represent? Should it be narrow or broad?" We have taken the large, diversified and broad approach. That’s why we’ve developed the Diapason Commodity Index (45 commodities) and have promoted the RICI. Where many indices focus on 25 commodities, we felt that to represent the asset class realistically, you needed more than that and it has to be based on either consumption, production, trade or liquidity. So we achieve better diversification and representation by including 45 commodities across geographies. It has to be diversified, because commodity sectors such as energy, agriculture and metals don’t correlate much and don’t move around the same fundamentals. It has to be liquid enough to be replicated. It has to be transparent. It also has to be non-subjective, and we try to incorporate this in our beta exposure. On the active side, there are different strategies in terms of enhancing around the curve, around the sector rotation, around arbitrages, volatility or around spreads.

RB, Watson Wyatt What demand are you seeing, in the active area of commodities? What are the opportunities in this area and who are the players?

BM, Morgan Stanley Morgan Stanley’s got a fantastic franchise and breadth in commodities but with this perspective it is clear not all commodities are sensible for all investors. Natural gas in the US is a fantastic commodity, and it appears under-valued further down the curve. But the persistent contango in natural gas, for fundamental reasons, is a big drain on return. We have always advocated these smarter ways of investing, and we see them being adopted by more institutional investors.

There are three things you need to ask about structural or enhanced indices. Does what you’re doing stay true to the original reason for investing? If you’re investing for diversification and exposure to geopolitical events, then you shouldn’t forgo any of that. Any enhancement should leave you in a similar diversification position. Secondly, does the enhancement make sense from a fundamental perspective? There are PhDs out there who can number-crunch until the cows come home and the data can look fantastic, but is there fundamental reasoning behind this?

The third thing may sound contradictory, but the data also have to make sense. If you are proposing a strategy, the data shouldn’t be the source but it still has to make sense before implementing that strategy. The result in our case is relative plays between commodities, some roll mechanisms moving early and later, versus the normal indices, and you see some rolling out further on the curve. All our strategies are governed by those three criteria, which isn’t the case for some of the ideas out there.

RB, Watson Wyatt There are a lot of different players in the commodities markets with different knowledge levels. There are people dealing in the physical markets, the oil majors for example, and the owners of assets themselves. What do you see as the anomalies if they exist?

BM, Morgan Stanley The markets are not as efficient as some of the financial markets. Similar to the currency markets, many players do not necessarily have a profit motive but rather a risk management motive. It’s not easy to exploit this inefficiency, for one, there are not enough people who have years of experience and understanding of the commodity markets. So it is similar to what we see in the physical market, we don’t have enough resource. Another aspect, because it’s a physical market, you are always at an informational disadvantage compared with the physical players. It doesn’t mean you cannot extract alpha, it is just particularly challenging due to the disadvantage of the normal active manager who doesn’t have a physical presence.

RB, Watson Wyatt Paul, as an alpha and beta participant, how do you view the structural active opportunities?

PT, Touradji There have always been active opportunities but it is challenging to take advantage of them. There is a dearth of talent and experience but there is also a greater opacity of information. In the foreign exchange market everyone has the same set of data to analyse but in commodities the majority of the participants struggle to get data. For example, in the coffee market, one vital set of data would be Brazil’s production for the following year. But every year there is a raging debate among the serious coffee players as to what production in Brazil was two years beforehand. So one can imagine the difficulty of getting forward data.

At the other end of the spectrum, the best set of data is provided by the US Department of Energy. It reports US onshore gas production for the first time two months after the fact, and a year and a half later it is often subject to major revisions, and it goes downhill from there. How do we overcome this? You can’t go out and hire a consultant or download data from Bloomberg. You have to throw resources at this in order to have a hope of being profitable.

RB, Watson Wyatt Do you need a presence and do you need to operate in the physical side of these markets?

FdW, PGGM It helps if you have a presence in the physical market. You see the flows, and you see what’s going on. Then again it’s difficult to extract alpha, because you can be right and still lose money.

SW, Diapason You may be involved in the physical, but do you get the full picture? And then, what has the market already discounted? Are you ahead of the curve? Markets try to look ahead. How much of this information has been discounted and how much is not already priced into the structure, how is the market positioned towards that information? Your analytical process towards information is key. Just information is not enough.

PT, Touradji It is a question of what you do with the information. For example, the US has been a relative weak point in base metals demand over the last year, so the physical market in the US has been negative on copper, aluminium, zinc and nickel. What have they done wrong? They were looking in their backyard. They may know their backyard better than anyone but you have to include Europe, China and the rest of the world in the picture. The implication was that the US has been weak for several quarters, whereas the rest of the world has been strong enough to compensate, as evidenced by the inventories.

Physical players have better access to information but they have to draw the correct conclusion from it. If you look at the statistics out of the US for several of these metals, it implies that demand is down 15% to 30% in the last couple of quarters, despite GDP being up 1% to 2%. Should we take that to mean that demand is haemorrhaging by a quarter? Or that there has been a sharp period of destocking which has caused the US to be weak, and perhaps there will follow a period of restocking, which would lead us to take the bullish rather than bearish view? More data is great in theory, but it can be dangerous if you do the wrong things with it.

SW, Diapason What’s more you can get it right in terms of demand, but you may have a supply surprise. A mine can be flooded, for example. There’s always an element of the unexpected that plays into it, and that can delay your scenario. That’s the same with the oil market and the geopolitics. Markets have many ways to wrong foot you in the short term!

PD, Commerzbank As we discussed earlier, commodities offer attractive portfolio diversification properties because they are not correlated with other asset classes. So while equities and commodities are not highly correlated, if you look at, say, the FTSE index, among the best performers last year were the miners. They are highly correlated with developments in the commodity markets. Although some of my own analysis suggests this is not a great idea, do we think that there is scope for using proxies for direct investment in commodities as an alternative to direct active investment?

SW, Diapason They are two different animals. An equity reacts to the management, to how they spend resources, use their balance sheet. The equity can go wrong because they have a pension fund problem. The investment has to be profitable. An equity has different risk and reward parameters from pure commodities. It also reacts more to the general equity trends. The commodity reacts to the supply, demand, inventory and monetary situation. There have been studies showing the different risk/rewards parameters of these two underlyings. But if you want to be invested in the commodity markets, invest in the commodities themselves.

BG, Pimco Management, for very good reason, might be hedging production, which means that you will not get the full benefit of a change, particularly an upward change, in a commodity price. Gorton & Rouwenhorst’s study showed that for individual commodities, the equity of the commodity producer was more highly correlated with the stock market than with the specific commodity that they produced, so it got very granular.

SW, Diapason There are also different parameters in costs and profitability. Many mining and agricultural operations have a cost base linked to energy, so sometimes their costs rise faster than the price of their output. It happened last year in Brazil with soybean producers and before that to the South African gold producers. They also have currency exposure to deal with. But overall, as a trend commodity production costs are rising.

Risky investment

RB, Watson Wyatt We’ve mentioned the risk issues related to commodities. Do you consider them a risky investment?

PG, SwissLife Asset Management One of the major risks is liquidity. If you look at the components of any commodity index, whatever the weighting, the liquidity of each single component can change suddenly. But that’s also an attraction to commodities. Because of regulation, we cannot invest in any hard assets or take any delivery risk, and that’s why we only invest in securitized commodities. The counterparty risk is linked to the manager, the firm which represents the manager, and the fund administrator. Those who invest in direct commodities face delivery risk and settlement risk as with any credit obligation. They may also face different types of currency risk. But those risks should then create an opportunity for returns.

BG, Pimco We closely analyse the credit capability of any counterparty that we choose, but we also do an operational due diligence on the commodity desk itself. We diversify among counterparties and particularly if we’re using swaps, we will call for frequent settlement and posting of collateral in between settlement periods. The investor should also consider political risk. You may do the right thing in making your allocation to commodities, in an amount that logically and analytically would be appropriate in the context of your total portfolio. But if your timing is unfortunate your commodities may go down in value after you invest. After several years of study, Ontario Teachers Pension Plan invested in commodities, specifically the Goldman Sachs Commodity Index. In 1997 the GSCI promptly went down over 40%. However, they had managed the political risk of that exposure appropriately, because they invested little enough that they would not lose their courage and get out of the asset class just because it went down.

RB, Watson Wyatt Given the volatility in this asset class, are timing issues important?

FdW, PGGM One of the biggest risks that we run is reputational risk. We were in a similar situation to Ontario Teachers the first full year we were in commodities. Equities went down. Commodities were even worse. That showed the commitment of our board. But like Ontario Teachers, we started with a small allocation so it didn’t hurt us that much. Secondly, we have multiple counterparties, 90% of our portfolio is done through total-return swaps, so there we have monthly resets, and we also have credit lines with all of our counterparties. As our futures portfolio goes, physical delivery is a risk. But that’s one of the main reasons we don’t trade futures on screen. We use brokers. We will always be responsible, but there’s a buffer.

BM, Morgan Stanley The uptake of commodity structured products specifically in Europe has injected a new issue for consideration. All the big institutions understand counterparty risk but a lot of these products with embedded credit risk have been dispersed to individuals who don’t always appreciate the credit risk inherent in the products they are investing in. Retail investors want access to commodities and many are restricted as to how they can get access. So these products fulfil a function and give access, so it’s not all that bad, but there are a few unknown credit risk bets being taken. I hope that most of the counterparties issuing them are of sufficient credit and standing that there won’t be any problems.

PD, Commerzbank The investor should follow the same investment route that they would follow for traditional asset classes in their investment portfolio. If they want exposure to commodities, they don’t have to buy some complex structured product – there are many delta one hedgers out there, which in fact makes up a reasonable proportion of our business. The commodity investor client base is clearly getting to grips with the risks inherent in the product but the key message we would offer to clients is simply invest in what you know, and understand the nature of the risk that you’re taking on. It is not in the industry’s interests to sell products which clients do not understand because this runs the risk of scaring them away from the business altogether. And for those of us trying to build a business, that’s the last thing we want to do. We’ve all learned that the shape of forward curves has changed dramatically over the last couple of years, and many investors weren’t aware of the impact that could have on their returns. As we go forward, investors will become even more savvy. They’ll look out for structures of forward curves as opposed to, say, looking purely at trends in the spot prices.