Commodities have some investors saying no

Institutional investors are wondering whether investing in commodities is worth the trouble, as the asset class has suffered an annualized return of -6.46% in the 10 years through June 30.

Indeed, the Bloomberg Commodity index has been negative each month for the past 12 months. The Bloomberg Commodity Total Return index, which includes the return of the collateral, showed a return of -5.48% over the same 10-year period.

Asset owners traditionally have invested in commodities as an inflation hedge and for diversification. While some are maintaining their allocations to protect against unanticipated inflation, the asset class' volatility and poor returns have other investors moving out.

Last year in particular, was a tough year for commodities managers, according to Pensions & Investments' asset owner data. The number of large defined benefit plans with commodity portfolios among the largest 200 retirement plan sponsors dropped to 55 from 60 in 2014 with total assets held by these investors down 19% to $22.5 billion.

Some investors have thrown in the towel.

Earlier this month, the $266 million Spokane (Wash.) Employees' Retirement System jettisoned its 4% commodity allocation when it adopted a new asset allocation.

“From our perspective, the risk-return trade off of commodities wasn't great,” said Jayson Davidson, partner and managing director at Portland, Ore.-based consulting firm Hyas Group, the Spokane fund's general investment consultant.

“The added volatility of commodities is not being offset by an added return benefit,” Mr. Davidson said.

Spokane is not alone.

The Orange County Employees Retirement System, Santa Ana, Calif. began phasing out of commodities in 2014. Last year, the board continued redeeming the commodities portfolio while retaining “toe-hold positions” through its multistrategy real-return managers, Girard Miller, chief investment officer of the $12.6 billion pension plan said at the time.

“If we begin to smell inflation in the future, we will be able to proactively reinstitute exposure quickly without starting another round of manager searches,” Mr. Miller wrote in an April 2015 e-mail to P&I.

Mr. Miller declined to comment on pension officials' current views on commodities as they await guidance on the pension fund's overall allocation from its new general investment consultant, Meketa Investment Group Inc.

“We retain a real-return position comparable to many public funds, and made significant energy investments as that market bottomed,” Mr. Miller said.

Commodity boosters say the asset class is misunderstood. They compare it to an insurance policy that doesn't come into play unless there is a need.

“Commodities has undergone an identity crisis,” said Jason Lejonvarn, London-based managing director, global asset allocation at Mellon Capital Management, a BNY Mellon Investment subsidiary.

Commodities is an asset class that belongs in a real asset or inflation hedge portfolio, he said.

Investors became disenchanted with the asset class when the price of most commodities “fell like a stone” two years ago, he said. This drop was not due to the lack of global demand for commodities, which was the theory at the time, Mr. Lejonvarn said. Instead, the drop was largely due to a supply phenomenon that occurs when companies that produce commodities move from investing in their businesses to an “exploitation phase” in which they shrink their companies, he explained.

“Investors' asset class expectations were too high,” Mr. Lejonvarn said. “They didn't understand the cyclicality of the commodity asset class.”

Commodities' poor recent performance has hit some asset owners particularly hard. For example, in an open letter posted on the pension fund's website in October, Rick Dahl — then the chief investment officer for the $12.5 billion Missouri State Employees Retirement System, Jefferson City — pinned the pension plan's poor return for the 2015 fiscal year on the underperformance of the plan's $1.4 billion commodities portfolio. The fund reported a-2.64% fair market value rate of return as of June 30, 2015.

“Commodities had an abnormally large negative event,” Mr. Dahl wrote. “The loss in oil was dramatic; whereby, a decade's worth of price gains was lost in a 12-month period.”

Asked for further comment, Seth Kelly, who succeeded Mr. Dahl as CIO, said in an e-mail: “We are taking a long-term view; we are structuring the portfolio for long-term success.”

Still, not all institutional investors are jumping out of commodities. In December, the $16.6 billion State Universities Retirement Systems of Illinois, Champaign, invested $324 million in commodities, with 75% of the retirement system's 2% overall allocation to the asset class going to the Invesco Balanced Risk Commodity Trust and 25% to the PIMCO Commodity Alpha Fund.

Illinois SURS officials view commodities not only as an inflation hedge but as a way of diversifying its portfolio, said Douglas Wesley, deputy chief investment officer.

“It's ... a diversifier to the extent that the price of corn and beans have nothing to do with stocks and bonds in the portfolio,” Mr. Wesley said.

The California State Teachers' Retirement System inflation team plans to reintroduce commodities, as part of its $1.77 billion inflation-sensitive portfolio by the end of 2016, according to the $188.8 billion pension plan's inflation-sensitive portfolio's fiscal year 2016-2017 business plan.

CalSTRS officials previously invested in commodities as an inflation hedge because commodities tend to perform well in inflationary periods, said Christopher Ailman, chief investment officer for the West Sacramento-based plan in an interview.

However, commodities falter when there is no inflation.

CalSTRS invested $150 million in commodities in 2010 but quietly discontinued the program at year-end 2014 because inflation wasn't an issue, Mr. Ailman said. In September, CalSTRS moved commodities to its inflation-sensitive portfolio from its innovation portfolio.

Evan Corley, head of natural resources in the San Francisco office of private equity manager Pantheon Ventures said his firm believes commodities have a place in investors' real assets portfolios because the fundamental drivers and value creation of commodities tend to be different from other portfolio drivers.

The drivers of revenue production and cash yield differ substantially from other asset classes.

“That said, you have to be very careful with the way you approach the sector,” Mr. Corley said. “There's so much cyclicality that ... it is hard to market time these types of assets. You have to invest across the cycles,” not try to jump in and out to catch the cycles at the right times, he said.

But other industry insiders consider commodities a tactical investment rather than an investment to hold for the long term.

“It's an interesting area. We don't always think it warrants allocation,” said Ilya Feygin, managing director and senior strategist at WallachBeth Capital LLC, an institutional agency broker. “It's a tactical play on current macro factors.”

Mr. Feygin added that commodities is a risky asset class with higher volatility than equities.

That said, commodities can be a repositioning play. Last year, the firm started looking at investing in commodities after shunning the asset class.

“It's been extremely underowned because of underperformance and it was extremely cheap,” Mr. Feygin said. A number of factors, including a lower U.S. dollar, currency uncertainty and a slightly higher risk premium, led to a “perfect storm,” Mr. Feygin said. “It's an allocation where investors don't want to have a static allocation.”

The dispersion of returns among commodity sectors “can be astounding,” Mr. Feygin said.

Agriculture was up about 2% for the year and silver was up 45%, while oil started to move up this year but is going back down, he said.

What's more, many investors' commodity investments have performed worse than the indexes because of the way some investments are structured.

Many of the commodity managers invested in futures contracts, betting on a so-called backwardation — that the price of the commodity would be higher at the time of the future delivery. The price investors pay for futures is the price they expect the commodity to be on the future delivery date of the commodity, explained Brad Conger, director in the investment strategy group of Philadelphia-based OCIO firm Hirtle Callaghan.

But commodities prices on delivery moved the other way — a contango.

“If you are a financial investor, you don't own a ton of copper or barrel of oil. What you own is a contract to deliver at some future point in time and, as a result, you are buying at a price that prices in the cost of storage and insurance. But it also embeds the views of others” on the future price compared with the price at the time the contract is purchased. Mr. Conger said.

So, commodity investors that invested in futures saw their portfolios dive lower than the already battered index returns because their portfolios were not only absorbing the drop in the commodity valuation but also the difference between the bet they made on the price of the commodity and the actual price of the commodity, Mr. Conger said.

Hirtle Callaghan recommends asset owners include commodities as “insurance” against inflation, Mr. Conger said. But he noted 95% of Hirtle Callaghan's recommended commodities portfolio is in company stocks rather than in futures.

“Quite frankly in the past four or five years, we've lived in a world of disinflation and so, it's not surprising that the thing that is supposed to hedge inflation underperformed,” he said. ”People don't regret having insurance on their house when their house didn't burn down in a fire.” n