Investors get active over commodities
Institutional investors are growing weary of traditional commodities index investing, leading some to turn to other ways of capturing the long-term benefits of the asset class with less of the short-term volatility.
“The concept of commodities risk premia is emerging,” said Kevin Norrish, London-based managing director of commodities research at Barclays PLC. “Investors are applying the risk-return framework of other asset classes - such as equities - to commodities as an asset class.”
Smart beta as applied to commodities is gaining traction, as well as active strategies that move along the futures curve or shift exposures among different commodities, sources said. Another key development is to combine commodities index exposure with underlying real assets.
The $7.8 billion Municipal Employees' Retirement System of Michigan, Lansing, is considering reducing exposure to passive and enhanced commodities indexes in favor of commodities-linked real assets, said Chief Investment Officer Jeb Burns.
The fund's asset allocation review is not expected to be completed until July, and decisions have not been finalized. The total commodities portfolio likely will remain the same or will increase slightly. However, the enhanced indexing portion of the portfolio will probably fall to a “foundational” 2% or 3%, with the remainder invested in real assets, Mr. Burns said.
“We believe in the long-term growth in commodities due to changing (global) demographics, growth in emerging markets economies and other factors that will contribute to greater demand,” Mr. Burns said.
However, some of the short-term benefits of accessing commodities through indexing have diminished, he said
In 2012, the fund embarked on a new commodities strategy by adding real assets with an existing enhanced indexing approach. Michigan Municipal Employees committed $180 million to directly invest in cattle and sheep ranches in Australia to be managed by Australian Pastoral Funds Management. Funding came from decreasing its 5% allocation to the enhanced commodities indexing strategy.
Simon Fox, London-based principal within Mercer's alternatives boutique, said: “We have a preference toward real assets as a way of gaining exposure to commodities and the underlying commodities prices. The attraction for us is that (real assets) provide an additional return driver on top of the commodities spot price exposure.”
In isolation, commodity prices are very volatile, and as a direct inflation hedge over the short term, commodities haven't delivered.
“Over a number of periods within the last few years, there have been major decreases in commodities prices without the equivalent falls in inflation,” Mr. Fox said. “In the long term, however, the idea that commodities increase in line with inflation has justification. Illiquid, real assets give you more of a chance to capture that.”
Even within the same sector, the risk-return characteristics of real assets can substantially differ, and diversification is needed, consultants and managers say. For example, investments in arable farms might decline as grain prices fall while livestock farms may benefit from the lower cost of animal feed. Timberland, on the other hand, has the potential advantages of lower storage costs and relatively more stable pricing in comparison to farmland.
When institutions began investing in commodities about a decade ago, they mostly did so through passive commodities indexes, which developed into enhanced indexing strategies that boost collateral returns and address problems of a purely passive commodities index, primarily negative roll yields. But in the past two years, performance has generally floundered even among some enhanced indexing strategies. Commodities hedge funds have also suffered, leading to heavy asset outflows at some specialist managers.
“The most common ways in which clients tend to access (commodities) exposure - benchmark index, enhanced index or specialist hedge funds — all have performed disappointingly over the past year or so,” said Kamal Naqvi, London-based managing director and head of EMEA commodity sales at Credit Suisse Group AG.
The Dow Jones-UBS Commodity index returned an annualized 0.1% while exhibiting volatility of about 17.9% over the three years ended Dec. 31. In comparison, the MSCI All Country World index added an annualized 4.3% with a volatility level of 17.5%.
The HFRX Macro Commodity Index returned 2.33% in 2012, compared with a 3.51% return for the HFRX Global Hedge Fund index. HFRX Macro Commodity also trailed HFRX Global by 0.93 percentage points in 2011 and 10.2 percentage points in 2010.
Disappointing returns, along with a period of higher correlation of commodities to other asset classes over the past few years, have led investors to reconsider, sources said.
Some pension funds - including the $253.2 billion California Public Employees' Retirement System, Sacramento; the $154.3 billion California State Teachers' Retirement System, West Sacramento; and the $12.9 billion Ohio Police & Fire Pension Fund, Columbus — have reduced, delayed or terminated their commodities strategies altogether.
After consistently losing money over the past several years, CalPERS, in the fourth quarter of 2012,reduced its commodities index portfolio by about half, to $1.5 billion, in favor of inflation-linked bonds.
CalPERS' commodities strategies had suffered several setbacks, according to sources who requested anonymity. The pension fund's investment policy restricts the amount of deviation away from the S&P GSCI Total Return index, which has been one of the worst-performing commodities indexes over the past five years, returning an annualized -7.6%. In addition, CalPERS has been reducing the internal resources available to manage commodities, sources said.
In an e-mailed response to questions, spokesman Joe DeAnda said: “CalPERS maintains a flexible asset allocation range between its investment areas, including within the inflation-linked asset class. This allows CalPERS investment staff to quickly make decisions based on market conditions and internal investment strategies. The increased allocation to inflation-linked bonds from commodities represents a routine implementation of this flexibility by CalPERS investment staff.”
CalPERS also has a 1% allocation each to forestland and infrastructure, which remained unchanged.
At CalSTRS, a long-only active commodities strategy is on hold.
Low expected returns
At Ohio Police & Fire, officials decided not to fund a 5% allocation to commodities. Commodities are not in the fund's optimization model because of their low expected returns, and “it was on this basis that OP&F did not move forward with this asset class,” according to David Graham, spokesman for the Ohio fund.
However, “in the long run, commodities still do a good job in hedging inflation and tracking economic growth,” said Hakan Kaya, portfolio manager at Neuberger Berman, New York, which manages about $2.1 billion in commodities, including long/short and long-only active commodities strategies.
Outflows from commodities indexes are relatively modest globally, while the number of contracts held in commodity indexes has risen slightly, indicating institutions are not abandoning the asset class, sources said.
Among those adding commodities strategies over the past year are the $26.8 billion Texas Permanent School Fund, Austin; the $26.6 billion Indiana Public Retirement System, Indianapolis; and the $26.4 billion South Carolina Retirement Systems, Columbia.
Net outflows during the six months ended Dec. 31 were estimated around $4 billion by Barclays, compared to a total of about $220 billion that tracks commodities indexes worldwide via index swaps, exchange-traded products and structured products.
“It's not a sea-change, rather an adjustment in an asset class that's relatively still new” to institutional investors, Barclays Mr. Norrish said. n
This article originally appeared in the February 18, 2013 print issue as, "Investors get active over commodities".