Increased volatility, negative roll yields and a correlation spike with equities are forcing institutional investors to separate the wheat of commodities strategies from the chaff.
“The commodities story is changing subtly from one where the tide is lifting all boats to one where the supply side of the equation is becoming really important,” said Ewen Cameron Watt, London-based managing director and chief investment strategist for BlackRock Investment Institute.
Excluding gold and precious metals, which Mr. Cameron Watt described as a “substitute for currency,” certain commodities will outperform others in an environment where demand is likely to grow more slowly. Volatility in the underlying prices will also vary.
Historically, there are two favored rationales to invest in commodities — diversification to equities and inflation protection, said Tapan Datta, principal in the global asset allocation division at Aon Hewitt based in London. “Both characteristics have become problematic,” he added.
The S&P GSCI composite index of commodity sector returns only added 0.52% so far this year, compared to 11.99% for the S&P 500. During the same period, the weekly correlation between the S&P 500 and the S&P GSCI has been about 0.49, compared to an average of about 0.15 between January 1976 and December 2011.
“Regarding the inflation aspect, that depends on your horizon,” Mr. Datta said. “In the shorter term, a lot of the swings in inflation do rise and fall with commodities; that's a no-brainer. But this close link runs into difficulties on a longer-term basis because it is also influenced by economic activity. After a while, commodities respond to demand and don't necessarily provide as close a hedge to inflation as (investors) might hope.”
Institutional investors have been boosting commodities allocations in the past several years; among the largest U.S. defined benefit plans, assets in commodities grew 13% in the year ended Sept. 30, according to P&I data. And a survey of investment consultants by investment data analytics provider eVestmentAlliance and money manager consultant Casey, Quirk & Associates showed alternatives categories — including commodities — dominating the list of “most-sought” asset classes forecast for 2012.
While institutions such as the $24.4 billion Texas Permanent School Fund, Austin, are still adding commodities, others have steered clear.
The Illinois Teachers' Retirement System, Springfield, announced in May the termination of its commodities strategy. Schroder Investment Management Ltd. and Gresham Investment Management LLC managed a total of about $340 million in dedicated commodities portfolios for the $37 billion retirement system, while Wellington Management Co. LLP ran a global tactical asset allocation strategy with an estimated value of $360 million.
The decision was made because of volatility within commodities, according to a statement from the fund at the time. Spokesman Dave Urbanek declined further comment.
The $146.8 billion California State Teachers' Retirement System, West Sacramento, is putting its long-only active commodities strategy on hold.
CalSTRS approved a $150 million allocation to commodities investments in 2010 but “the funds are not yet invested nor do we have a timeframe established for when to do so,” spokesman Ricardo Duran said in an e-mail. “The market environment is volatile, thus our strategy includes careful consideration of our entry points. By being active, investment managers will have the discretion to find entry and exit points for the positions that account for this volatility. ”
A market environment where the (West Texas Intermediate) oil contract can fall 10% during a month and then rally 9% in a single day is one in which “commodities strategies — and investors — must be conservative or patient, preferably both,” said Jonathan Berland, managing director at Gresham Investment Management LLC, New York.