Once a diversifier, commodities now correlate highly with equities

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.

The medium-term price outlook for commodities is fragile, Mr. Datta said. “But even thinking strategically for the long term ... there remains substantial uncertainty over the level and volatility of returns,” Mr. Datta added. “That may be deterring some investors.”

Most institutional commodities portfolios are dominated by long-only passive strategies using derivatives, which not only capture the underlying price of the assets but also roll yields and collateral returns, sources said.

“The problem in the last five years is that commodity prices have been relatively OK, with some exceptions,” Mr. Datta said. However, roll yields that historically added as much as a few percentage points in returns have been persistently negative. As a result, commodities returns have been affected negatively, he said.

Some institutions have attempted to mitigate the volatility and risk of long-only strategies by investing in active and/or hedge fund commodities strategies. For example, about 75% of the Sacramento-based $235 billion California Public Employees' Retirement System's $3.6 billion commodities portfolio tracks the S&P GSCI Total Return index and the remainder targets active commodities strategies.

“Investors do recognize the potential difficulties of long-only strategies, but the snag is that when you get into long/short, it's hard to say whether investors are getting systematic exposure to commodities, and therefore, it becomes a question of the degree to which it belongs in the commodities bucket at all,” Mr. Datta said.

Others have focused on niches. For example, forestry and timberland are commodities in which “biology is entirely on your side,” BlackRock's Mr. Cameron Watt said. Storage cost for timber is a benefit to investors. In comparison, the storage cost of corn or copper can hurt returns when supply exceeds demand.

“Investors make money from the nexus between supply and demand,” Mr. Cameron Watt said.

To help mitigate the effect of negative roll yields, S&P Dow Jones Indices LLC has introduced several new indexes looking “more closely at the relationship between contract expiration and the futures curve,” said Jodie Gunzberg, New York-based head of commodity indexes at S&P Dow Jones Indices. The most recent, launched in January 2011, is the S&P GSCI Dynamic Roll index. Using a combination of actual and back-testing data, the S&P GSCI Dynamic Roll index returned an annualized 14% in the five years ended June 30. In comparison, the S&P GSCI lost 24.5%, according to data provided by the firm.

Another index — the S&P GSCI Enhanced index — returned -6.4% during the same five-year period. The S&P GSCI Enhanced dynamically and seasonally attempts to minimize the effects of negative roll yields for eight of the 24 underlying energy and agricultural commodities that's most difficult to store. “It's not only the roll (yield) itself, but also the impact from the roll (yield) in different sectors,” Ms. Gunzberg said. As of Dec. 31, about $80 billion in assets tracked the S&P GSCI family of indexes.

Mr. Berland at Gresham believes that investors “can't own commodities without roll yields; it's the cost of storing, feeding and insuring what you own. When you think about owning a piece of property —if you have to pay taxes or undertake maintenance on that property — you wouldn't call that cost roll yields, would you?”

The argument that commodities do offer diversification benefits to equities and bonds still stands, said David Hemming, commodities portfolio manager at Hermes Fund Managers Ltd., which manages a total of about £29.3 billion ($46 billion). “Within an economic cycle, commodities and equities perform at different times. Equities are more forward-looking and do well on the expectation of growth, while commodities (do well) on the realization of growth.”

Hermes, which is owned by the £35 billion BT Pension Scheme, London, manages about $2 billion in active commodities strategies.

Data going back to the 1970s indicate “there were only four years in which the S&P 500 and the S&P GSCI were both negative,” Ms. Gunzberg said. Every time this has happened, there has been a demand crisis, and in each case, the magnitude and duration had a direct relationship to the magnitude of the crisis. We would expect that correlation will drop back to normal lows given the same fundamentals.”

Slowing growth in China has also been a major impetus for the heightened volatility recently in certain parts of the commodities sector, largely due to demand generated by the world's second largest economy. However, Mr. Cameron Watt said, there are also opportunities for active management as a result.

“We're looking at an economy that is still growing. It's not a question of it being in recession, the demand is still growing,” he added. “This is a country that's generating between 40% and 50% of the world demand for many commodities.”

Data Editor Timothy Pollard contributed to this report.