Participants
RB, Watson Wyatt Commodities is interesting, particularly as a diversifying asset class. We’ve been talking to our client base in this area for the last few years. However, the take-up of commodities from the institutional base is still limited. I think when investors are looking at this asset class, it is from a beta, or an asset exposure perspective. But things are moving quickly and I think there are interesting alpha opportunities in this area as well as opportunities for different structures that might be more appealing than some of the benchmark indices. I want to ask Jelle, as a long-standing investor in commodities, to describe PGGM’s experience and how its investments evolved.
JB, PGGM Our basic proposition is that we promise pensions linked to wage inflation. So we need investment returns to meet our liabilities. A lot of investment risk is equity risk – that is what the market offers, there’s a lot of liquidity there, and over the years PGGM’s allocation to equity has increased at the expense of fixed income.
But with a growing allocation to equities the need for diversification grows and so the allocation to alternatives has also grown – initially real estate, private equity. In 2000 commodities were added. The question “What should investors look for – alpha or beta?” is interesting, because initially we went into commodities purely on the beta case, diversification of our strategic mix with more or less fixed allocations to different asset classes. So my mandate was to passively implement commodities and get exposure.
After a couple of months we recognized that it’s an interesting asset class for alpha too, so we asked for some space to pursue this. On the beta case, we came to the conclusion that the market indices didn’t quite suit us. Or at least for our purposes it seemed to us that energy drives the characteristics we want. So we have increased gradually the weight of energy, and started off with the Goldman Sachs Commodity Index, which already had the highest energy weighting. We are now at 40% pure energy and 60% the index, which is itself about 80% energy. Traditionally, we pursued active possibilities as a kind of tracking error around our allocations. I don’t think that finding alpha in the commodities space is easy, but there should be more opportunities than in more efficient markets.
RB, Watson Wyatt James, perhaps I could ask you for your observations on this?
JW, Hermes From a UK pension fund point of view there are two things. One is we’ve been fairly undiversified, we’ve tended to track equities, with big chunks in UK equities and bonds, and a decent chunk in property. The other thing about us and many pension schemes is there’s a substantially under-funded deficit. At the same time, the trustees are trying to reduce risks, and those two things are not necessarily compatible. So what we’ve been tasked to do over the last couple of years is find ways in which we can reduce the risk, but without having to go back to the sponsor for huge amounts. So we look at ways in which we can diversify and, clearly, commodities, from a beta aspect, is very good at that. The fact is that it’s largely uncorrelated with equities and possibly negatively correlated when things really go bad. If things go not too bad or go a bit bad, commodities are useful. When things go really bad, commodities are fantastic. The vast majority of the benefit comes from the beta. I’m sure there are alpha benefits there as well. But beta is the key thing for us.
MS, AIG I think one thing we will see is convergence between beta and alpha; in fact we are already seeing it. Jelle has said he’s beginning that convergence. He started at “Okay, pick the GSCI” and then there was another level of “Well, actually, more energy’s a little better” and, “Now we’re going to start rolling some of the futures contracts ourselves”. I think the convergence between alpha and beta will get to the point where people will be more comfortable with alpha generation, and end users will be more comfortable allocating some funds to people who make those kinds of decisions.
RB, Watson Wyatt Michael, do you have any comments?
ML, Deutsche Bank What’s been interesting over the last 20 to 30 years, particularly in the US, is how the balance sheet of the consumer has changed from money market and bank deposits to bonds and equities. More people are over 35 as a proportion of the total workforce, so they’re preparing for retirement. The demographics should be arguing powerfully in favour of something that provides some hedge against that part of your portfolio that is becoming increasingly a large chunk of your wealth, excluding housing. Commodities fit perfectly inside this mix. So when equity returns are under pressure, bonds and commodities do quite well, and when fixed-income returns are under pressure, equity and commodity returns perform strongly.
My feeling is that commodities are a bit like emerging-market assets in 1985, where it took time for investors to be comfortable with investing. Similarly we may find that all commodities need is time and familiarity with the idea that they’re not that risky.
BM, Morgan Stanley It is quite challenging to approach commodities from an active perspective. There are differences between commodity markets and bond and equity markets. You don’t have the same level of information and distribution in commodities as you do in some of the other asset classes, just because it is such a physical market and it is, to a great extent, dictated by near-term supply and demand fundamentals. That information isn’t always freely available and is generally more available to those embedded in the commodity market itself. The information makes it difficult for fund managers or anybody else trying to do a tactical misweight between commodities to add value. I’m not saying it can’t be done, I’m just saying there are challenging elements to it.
RB, Watson Wyatt Bob, you have something you’d like to add?
RG, Pimco All the comments we hear about investing in commodities are about commodity futures – indices, enhanced indexes, things of that nature. Ian and Jay have more experience in the equity of commodity producers than in actual commodity indexes. Let’s be clear that so far the comments have dealt with commodity indexes as an asset class, they have not dealt with equities. In terms of adding alpha in commodity futures it’s nice to have knowledge of the cash markets, it gives you better market information on what will happen in futures. But if we are talking about commodity indices, by definition we are talking about collateralized commodity futures, and that collateral can also be passive or active. It does not make sense to have that collateral simply sitting in a bank. There are significant opportunities for its active management, and that is an inherent part of exposure to commodity indices as an asset class – another chance to add alpha.
RB, Watson Wyatt I would like to turn to the two gentlemen here that actually deal with the equity component. Ian?
IH, Watson Wyatt Companies involved in mining have offered extraordinary gains as a result of projects being developed or discoveries being made, and these can offer opportunities even when commodity markets are weak. So the idea that you’re investing in a company just to play the commodity game is only a part of it. The real interest is to find one that has real growth prospects and is not dependent upon what happens to commodity prices. Bear in mind that in real terms commodity prices have fallen and the idea of long-term real prices going up is a relatively new notion. But the two games are completely different. The commodity futures trader is playing backwardation and contango: throughout the 1990s the game was playing the carry trade in the gold market. Some of the world’s richest families have made their money as a result of the commodity gain. Abba Resources, for example, discovered and participated in the construction of a diamond mine in Canada, where a very small investment has turned into something worth today around $2 billion. That is the excitement for the investor – something that costs you 20 million becomes worth 2 billion. That is where the equity side of things offers something particularly special.
RB, Watson Wyatt An interesting, different view we don’t hear that often in a world dominated by collateralized or index-driven financial investment in commodities. Jay?
JB, CSAM I think if you’re looking for alpha, equities are better, because equities are call options on assets whose value are themselves derived from an underlying commodity. So commodity equities are an option on an option commodity. When you’re buying an equity, not only do you take advantage of commodity price increases, you get operating leverage as well. If the copper price goes up 10%, sales go up 10%, but net income rises by a multiple of that, which in turn will drive the value of the equity. Commodity companies also grow by adding reserves and as prices rise they can validate entirely new business models (such as the oil sands in Canada). So equities offer huge amounts of alpha versus commodities. In the 1970s commodity equities grew many multiples of the growth in commodities. Of course commodity equities provide little benefit on the diversification side. They will move with the broader equity markets; certainly they’re lower beta versus the equity market, but they’re still going to move with it.
JB, PGGM By investing in equity, you invest in an entrepreneurial effort and therefore you expect to have your share in it. To what extent do you think that commodity-related equities are any different here from other equities?
IH, Watson Wyatt It depends at what stage you want to get involved in a particular company. In the resources area you can go and buy what I would call a real estate claim – right at the edge in terms of speculative investment. But you might buy a company whose reserves are being delineated, or you have some idea of what it has in the ground. There you can directly assess whether or not those reserves are being properly evaluated. There is no divine right for large companies to find resources and most large investment houses nowadays have skinny research on smaller companies. Most exploration is done by smaller companies and your own information network can count for a lot.
JB, CSAM What’s different, especially in oil, is that if you’re drilling a $30 million or a $50 million well, the chance of finding a billion barrels is the same whether you’re a $100 million market cap company or you’re a $200 billion market cap company. Hence for a similar cost the upside can be equally huge, whether you own a small-cap or large-cap stock. Investors can buy small companies that might become really big, but the fundamental geological risk is the same.
MS, AIG But we’re talking about two completely different things here. The underlying assets we’re talking about are broadly speaking all commodities, but the sources of the returns are totally different. Providing risk capital, for example, to sink that $50 million oil well is very different to investing in commodity futures, where you’re effectively providing price insurance, if you will, to people who want to hedge.
RB, Watson Wyatt One question for Ian: given what we’ve seen [in commodities] over the more recent period, have you seen changes in the dynamics of demand for your types of products?
IH, Watson Wyatt There have been two significant changes. The first was the end of the Cold War, which opened up parts of the world previously closed for investment. The other big difference is this open architecture world, which is embracing a free trade world. For the first time multinationals are prepared to invest and source product from the cheapest country of production. That has offered huge opportunities to some Asian countries, which clearly have significant advantages. We’ve more than doubled the economically active world in one fell swoop.
RB, Watson Wyatt Bob, any comments on this issue?
RG, Pimco I would just say that some people are looking for the portfolio benefits of adding commodities as an asset class, whereas Ian approaches it from the standpoint of investing to make money. You may invest to make money, but you also build a portfolio to improve your expected risk adjusted returns for the entire portfolio. And those are different reasons to invest in commodities. Depending on which of those you’re more interested in, it may affect whether you use equities or the unleveraged long-only commodity futures.
RB, Watson Wyatt Let’s move on. How do you actually invest in commodities? Do you use a swap and index future or the underlying futures? What index do you use? And if you like this asset class, how much do you put in it?
BM, Morgan Stanley The first question is what strategy risk you are willing to allocate to commodities and how you are allocating your risk. Extending beyond index risk and returns, additional risk can be taken in commodity exposure, the backing collateral, or both. So the investor needs to consider: “Am I going to do a passive-only exposure? Or am I going to take on some further risk in my allocation? And am I going to allocate that risk budget to commodities, collateral or both?” Secondly: “What am I going to use as my benchmark?” By and large the institutional investment community has used either GSCI or Dow Jones AIG, but investors are increasingly tailoring those benchmarks. The third question is: “Which investment structure or vehicle do I prefer for my exposure, do I build the exposure in-house through my own resources?” Further questions are: “What percentage should I allocate? And what is the timing of my allocation?” And finally, for non-US investors: “Do I currency hedge my exposure?” Regarding hedging, we’ve generally seen most investors look at commodities on their overall portfolio level, and they don’t necessarily hedge the commodity aspect, but hedge as appropriate for their entire portfolio’s exposures.
JB, PGGM I think the reason a lot of funds are afraid to get in is that they think they need to know all the ins and outs of the different commodities markets. To get started, the knowledge of how to handle derivatives operationally is much more important than this. We bought into one aspect of the market, the power to diversify the asset mix, and we could capture that via an index. When you progress you get a better view, and you start making your own choices. That’s why we moved to more energy and more active management. We have a limited number of people managing a relatively large sum – we cannot know everything. That is not necessarily a disadvantage, it helps to focus on the main issues.
RB, Watson Wyatt James, it might be worth you talking through how you’ve approached some of these issues.
JW, Hermes If you’re in the early part of investing in commodities, where you’re looking for passive exposure, you should be able to do most yourself without a huge amount of extra personnel expense, and that’s what trustees want. In terms of choice of benchmark index, if you’re talking about the sort of low-end allocation of sub-5%, it probably doesn’t matter much. Where it might matter is if you had a really sizeable allocation, 10%, 15%, 20%, because then what you’re trying to do is build an exposure that somehow best diversifies your whole portfolio against your liabilities. In terms of allocation, there’s always a tension between where you think you would like to be and where you think you can get your overall owners or trustees to go, and it’s a gradual process. We’ve done some recent work on what we would advise, what we might invest if we had a blank sheet of paper: it suggests you really wouldn’t ever have much less than 5%. If you’re heavily exposed to bonds, then, yes, 3% is probably what you might want to have. If you’ve got a more balanced portfolio, then 7% to 8% and if you’re trying to get really high returns, you’ve got lots of equities, that’s when it tells you you want 20% plus – that’s were you get the fantastic diversification benefits.
JB, PGGM We’re all talking about asset allocation, but a 5% asset allocation in terms of P&L swings is much more. In our experience, our 4% to 5% allocation to commodities has larger P&L swings than our 30% plus allocation to fixed income.
RB, Watson Wyatt Bob, do you want to come in here?
RG, Pimco About 13 years ago I had my first consultation with an investor considering an allocation to the asset class. Invariably, when they run an unconstrained mean variance asset allocation model, they come up with a lot more than 5% that they would like to have invested in commodities, assuming very conservative returns for commodities. If they run an asset liability model, they want even more commodities, because you get a bit of inflation hedging benefit as well. Then it become a question of how much my investment committee will really allow me? That number invariably comes down and almost all of it comes to around 5%. Not coincidentally, some of those same asset allocation models show that if you start at zero and go upwards, depending on your assumptions, it will take you about 5% or 6% allocation to commodities to simply get onto the efficient frontier. For the most conservative investor, the one that wants the least volatility, with some pretty conventional asset class assumptions, he’ll want 4%, 5% or 6% allocation to commodities.
RB, Watson Wyatt That brings us to benchmark choice.
ML, Deutsche Bank The ones we hear about most are the Goldman Sachs, the Dow Jones AIG and the Deutsche Bank indices. The most important characteristic is for the index to deliver returns that diversify the risk of holding stock and bonds. The reason people focus on a large energy weight in an index is that if you look at the sources of returns over the past 20 years, it’s only come from the energy sector. If you look at total returns of corn, wheat, gold, aluminium, whatever, they provide you with low or even negative return, all they provide you is diversification, reducing the volatility of your index. Whether that changes is something we’ll discuss, but historically you’ve been faced with contango and negative roll yields in markets outside the energy complex. Whereas if you look at a typical energy index, it will return you something like 9% or 10% per annum, just from the roll return, and obviously now that situation is changing, which is making things quite interesting.
RB, Watson Wyatt Jelle, have you got something you’d like to add?
JB, PGGM Benchmark choices should depend on what you try to achieve with your commodities investment. We think in several scenarios and in each different asset classes will have greater returns and others will lose. The thing about commodities is, if things go bad it’s nice to have them; if they really go bad it’s great to have them. That is particularly true for energy – it has the closest links to our other assets and therefore provides us the best diversification. If your goal is to get exposure to as wide a range of commodities as possible, you should have an equally weighted commodity benchmark. If your goal is to get exposure to Chinese economic expansion, metals might be the best choice. In general you have to recognize that commodities is not one asset class. We found that commodity subclasses between themselves can be just as low or negative as their correlation with equities.
RG, Pimco The first demonstration of the powerful investment benefits of a commodity index had no energy in it whatsoever: that was my paper published in 1978 – and energy contracts were not traded in the 1970s. If you look at the historical back testing of something like the Goldman Sachs Commodity Index, you see it had these same terrific portfolio benefits, and positive returns in the 1970s, again without energy. So it’s not all about energy and not all indices are highly dependent on energy. It’s more about the broad exposure to fundamental drivers of return.
MS, AIG Generally we believe a benchmark should be representative of an asset class as a whole and not just a specific sector. To keep the index from being concentrated in any one sector, such as energy, you need some kind of diversification rules. The DJ-AIGCI has rules to ensure that the index remains relatively diverse. A diverse index allows investors broad exposure to the asset class without having to make directional bets on single commodities. Diversification rules also take advantage of the relatively low cross-correlation between commodities that Jelle mentioned and can generate the added returns by “forcing” the index to sell commodities that have gone up in price and buy those that have not.
JB, PGGM The benchmark for us is not only about the investment proposition, it needs to be transparent and public as well, for instance. We need products and instruments to replicate the benchmark. I think one consequence of that is that most benchmarks concentrate on exchange traded futures, but some commodities, coal, maybe in future power or CO2, may have the same investment/diversification characteristics, but don’t fit in these indices, and we have to look for instruments that provide the same kind of transparency and openness.
RB, Watson Wyatt It is interesting to reflect on where our client base is coming from and it does vary by client. There are two things going on, one is a diversification play, the other is providing risk capital to the market, in the sense that you’re going to get some return for providing that capital to the market, albeit in a volatile way. The choice of benchmark index is more difficult, because it’s a function of investor beliefs about where they think prices are going and whether they think there’s going to be more roll return in certain areas.
JW, Hermes If you’re talking about 5% [allocation] within a pension scheme, I don’t think it matters too much which index you choose. The Goldman Sachs index is a nice straightforward one, which trustees are comfortable with. When index choice really starts mattering is when you get up to 10% [allocation] or so.
ML, Deutsche Bank But Jelle was saying that 5% can actually make a huge swing. The range of index products is therefore important and substantial. For example, the Deutsche Bank Mean Reversion Index has less than a 10% allocation to energy while the Goldman index has around 80%.
RB, Watson Wyatt Let’s turn to return expectations. Ian made an observation earlier about potential long-term cycles. Ian?
IH, Watson Wyatt We have seen a dramatic change in the commodity market with the advent of China onto the world scene. In the case of liquid hydrocarbons I subscribe to the view that there is a distinct possibility that we will not be able to increase production much. I have a distinct problem with the overall pricing of gasoline on a global basis. I think we will have to change our consumption patterns to prevent what could be a very difficult market. Because we have just at least doubled the consuming population, 75% of all demand growth is coming from the emerging world. It is now probably accepted wisdom that we are in for a long cycle rather than a short cycle. So are prices near their peak? Prices in real terms are away from their real peaks. The only exception is oil, where we are in real terms at or close to all-time peaks. It is difficult to believe in a lower pricing environment, at least for the foreseeable future.
RG, Pimco I agree. For instance over the past two years the long-dated crude contract has risen from being in the mid-$20s per barrel up to around $60. The returns to commodity index investment are driven by things other than the absolute level of commodity prices. They are driven by unexpected changes in factors that affect spot prices, because things that are expected are already embedded in the futures pricing. So you’re assuming some price risk that producers don’t want, and you are paid for that. An additional aspect of return is that you can gain because buyers of commodities need the certainty of supply and, in periods of very low inventories, will bid up the current price, yielding what economists call “convenience yield”. Finally, commodities are not highly correlated with each other. This creates an inherent benefit from rebalancing commodity portfolios. We also have a tight infrastructure situation: not just supply but also storage, transportation and processing. Bottom line, the fundamental drivers still apply. The movements of commodity index returns are still likely to be uncorrelated with stocks and bonds, so you will still get the diversification benefits.
RB, Watson Wyatt Thank you. Jay, as a player in a slightly different area, what are your thoughts on returns?
JB, CSAM Even if the futures markets for all these commodities stay where they are, equities are still not reflecting the futures market prices.
Energy and mining equities would all be worth 20%, 30%, maybe 40% more were they reflecting those future prices.
RB, Watson Wyatt So the two markets are telling us different things?
JB, CSAM The equity markets have a long history of valuing things on mean reversion, and if this is indeed a long cycle, we might not go back to the long-term average for a long time. What’s more, markets may eventually settle down at a much higher level of long-term average. In the case of energy prices this is certainly the case.
RB, Watson Wyatt Matthew, you have some thoughts on this subject?
MS, AIG One of the things that Benno made reference to is that we’re talking about futures markets that are theoretically in front of much larger physical markets. Crude oil is a good example—open interest in all the crude oil contracts on Nymex is only something like 10 days’ global oil production. So I think it is important to recognize that the vast majority of these markets are still small relative to the physical market. There is also the potential for increased demand for risk capital. It is pretty clear that we have some issues at present with supply that will require additional investment. The money for that investment is going to come not just from oil at 60 bucks a barrel, but also from banks, and banks are going to require hedging. That then increases the demand for price insurance by hedgers and thus the risk premium received by investors.
RB, Watson Wyatt Jelle, you’ve got some thoughts on this subject, I suspect.
JB, PGGM I agree that we are in a problem long term. It will be hard to increase energy production to keep up with demand. I am convinced that prices will go higher before we move to an alternative. You can subsidize what you want, but price will trigger the change to alternatives. In the shorter term, five years out, I expect prices to be volatile, but production infrastructure constraints will limit the downside.
RB, Watson Wyatt Benno, how does this look from the trading area?
BM, Morgan Stanley I also think we’re in a long-term bull cycle. There’s been massive under-investment in the infrastructure. I don’t think anywhere in the historical commodity index returns have we seen something on the scale of China and potentially India and Russia, and other emerging economies, and their incredible development cycles and demand growth. So this is an unknown to us and therefore if you look at the current decomposition of returns, spot prices on average over the past 35 years as a component of the commodity total returns have been in the vicinity of 3% to 4% (using the Goldman Sachs commodity universe). We are in an environment where spot returns are in excess of 40% for this year, so it really is a whole new world for returns, the composition of returns and the underlying supply and demand dynamics. And in an environment where we are increasingly concerned about potential rises in inflation, commodities are behaving as investors expected: strong positive performance. Key to investors, however, is that commodities provide diversification if equity markets are depressed again. So most investors have not entered the market with the expectation of exceptional returns or inflation protection, but with a focus on having unsynchronized returns in their portfolios. This diversification focus is reflected in the relatively small allocations of between 5% and 15% to commodities.
RB, Watson Wyatt James, your thoughts on returns? You talked earlier about diversification.
JW, Hermes What does this all mean for pension schemes and for the promise that trustees have got in terms of actually paying pensions? We’ve obviously seen a period where the positive supply shock, which has been China and India coming onto the market, has been hugely beneficial in terms of inflation. The question then is over the next five, 10 years is, if we’re right about commodity prices, what does it mean for general inflation? What does it mean for servicing our liabilities? One of the options is to hedge our liabilities by buying index-linked gilts. But the UK index-linked market isn’t big enough for us and it only actually returns about 1.1% to 1.3% in real terms. Having exposure to commodities sounds very important for a pension fund.
RB, Watson Wyatt Our view is that commodities form part of a variety of premia that institutional investors should access: equity risk premium, credit premium, skill premium and what I would call illiquidity. We would look at an investment in commodities as the provision of risk capital in the expectation of a return, just as you would put money into private equity and real estate. I would be interested in other views on the assumptions people are making about real returns.
IH, Watson Wyatt The reason that commodities have suddenly become prominent from an asset allocation point of view is clearly that equity assumptions were driven adrift by three bear market years, and people have trawled around for a new investible universe.
RB, Watson Wyatt People want to hold things that have different risk and return characteristics in their portfolios. Commodities are one of those. I think investors are finding it quite difficult to find other asset classes that look attractive, because we’ve seen a general compression in yields. The big risks for pension funds is the mismatch between growth and assets and whatever they’re holding to match liabilities, be they bonds or swaps or combinations of those instruments. Michael, do you have any comments on returns and risk capital?
ML, Deutsche Bank The concern I have is that if you look at the sources of returns for a commodity index this year, it’s only coming from the spot return of crude oil, that’s gone up over 50, whereas the term structure has shifted in a weird way, which people wouldn’t have predicted a year ago. If this persists, you will start 2006 with an expected roll return of negative 25%. So you need spot returns in energy to go up 25% or WTI rising towards $80 for your energy index just to break even. So that long-only passive approach, which has performed extremely well since 2002, seems to me to have become a more vulnerable and dangerous strategy.
BM, Morgan Stanley A key thing we’re thinking about is how much liquidity is there? Can the market absorb institutional inflow? I don’t think there is a magic number, but we have analysed some of the less liquid markets, like livestock, agriculture, and you cannot see any discernible trend in these less liquid markets that would suggest investor inflows are changing dynamics.
JB, CSAM As availability or scarcity becomes an issue, as we move to more producing at capacity, the demand for inventory grows up. What was a suitable level is no longer suitable. If you go back four or five years, inventory levels used to be way above current levels. I think it’s right that the contango in future prices is signalling more inventory should be held because we will need it.
BM, Morgan Stanley The other thing to bear in mind is we’ve had a fairly stable year for crude oil supply. We cannot afford to lose major producers. If that were to happen, the term structure would dramatically change.
RB, Watson Wyatt Let’s talk about risk and risk management issues from an investor’s and a management perspective. Matthew.
MS, AIG From a risk management perspective, the kind of contracts that you’re going to have if they’re index based, or the value of the equities that you’ve invested in via a manager is straightforward. Both in Europe and in the US, investors increasingly view this asset class as a risk management tool in itself. If they have a portfolio that is, say, 60% to 80% in fairly traditional assets their approach to commodities is: “I’m going to dampen the volatility in my portfolio by adding a negatively correlated asset.” In the context of some recent allocations we’ve seen, returns have played a backseat to these “risk management” arguments.
RB, Watson Wyatt James, how do you look at risk in this area? From the portfolio context, but also how do you do it and how are you going to manage it?
JW, Hermes We’re more interested in the diversification benefits of commodities. When we actually start thinking about how much risk we are possibly taking out of the scheme by putting the amount, say, 5%, 10% into commodities, and then compare it with the risk you might be putting back in again by putting a little bit of alpha in, they’re very different quantities. The alpha is very small compared with the beta, and that’s probably the most important. It obviously comes onto the next question in terms of whether you do it as an overlay or an asset class, because one of the things we will have to look at is if we have 45% return in the first six months of the year, it’s going to be very overweight in the scheme, it’s going to have a very big impact on the scheme, and then there’ll have to be some rebalancing.
RB, Watson Wyatt Let’s tackle that subject now then: overlay or asset class?
IH, Watson Wyatt It’s a question of how an individual portfolio is run. Some people have core satellite strategies; others have completely different strategies. If you’ve got a core satellite, it’s probably an overlay.
RB, Watson Wyatt Philosophically commodities are a separate and distinct asset class from equities or bonds. Commodities are not capital assets: equities and bonds are – they can be valued on some type of net present value basis. You can get exposure to commodities via an overlay, just as you can with equities. However, when the decision to include them in a portfolio becomes one of treating them as a separate asset class, you then get exposure to expected changes in prices of this non-capital asset. Let’s talk about global trends particularly in terms of products and strategy development. Matthew?
MS, AIG First of all, when we talked about the inflow of risk capital, one of the things we thought interesting was the increasing amount of new commodity futures worldwide. This is not that different than what you saw in the 1990s when people were concerned by the equity risk premium going to zero. In response to increased demand for equities, you had a whole bunch of companies going public, although maybe some of them shouldn’t have. You’re starting to see signs like that in commodities: increasing amounts of new commodities either being traded as Jelle referred to earlier, hedged or new futures being listed on individual commodities such as soybeans in China or coal in New York.
Secondly, from a product perspective, you have a great concept in exchange-traded funds. There has been no commodity index based ETF launched in the US despite 75% or so of of the global ETF market being traded in the US. That is one of the things that will unlock potential interest among the retail sector in the US and will have broader implications.
JB, PGGM I expect the disappearance of asset allocation. We will concentrate more on risk allocations and, moreover, marginal risk allocations. And then the old discussion about commodity futures or resource stocks becomes in a way irrelevant. If you want a price risk you go to a resource company, if you want the roll you go into futures, and if you want the roll without the price risk you might hedge it: moving more into strategies and getting an overall package of risk premia.
IH, Watson Wyatt Correlations between markets have been getting closer and closer, whereas correlations between the sectors have not. If asset allocators and consultants are to be realistic, they will actually be more conscious about picking sector skills than ever.
RB, Watson Wyatt Bob: thoughts on future developments and trends?
RG, Pimco Thirty years ago the words “commodity” and “investment” could not be spoken in the same sentence. Now investors are recognizing the benefit of commodities as an asset class. Increasing institutional money into long-only commodities, active or passive, will reduce some of the risk premia we have talked about. That’s a good thing for producers and ultimately for consumers. That will not mean that commodities become a bad thing as those risk premia are reduced, because some of the factors of returns that we’ve talked about will still be there. I see commodities becoming more mainstream and more choices to get your exposure to changes in commodity prices will be offered by investment banks.
RB, Watson Wyatt Jay, do you have any thoughts?
JB, CSAM It’s early days for investing in commodities and enjoying the returns. And if you’re looking for alpha and not just diversification, if you’re still looking for returns, commodity equities still offer considerable upside.
RB, Watson Wyatt Benno?
BM, Morgan Stanley We’ve reached a stage whereby we have successfully dispelled some of the myths that have clung to commodity investment, and I think we probably have most investors comfortable with understanding what they’re investing in. So the next three to five years from an investor perspective, I think we will see the major decisions of whether commodities can play a part in their portfolios or not. I think we’ve crossed that first part of the educational stage.
RB, Watson Wyatt James, anything to add?
JW, Hermes It might be slightly slow-burning but I think pension funds will continue to invest in commodities, not just because of diversification but also because of inflation risk. I think as pension funds, we’ll spend more time seeking out alpha, because we’ll realize it’s that much more difficult to find these days, and actually where alpha exists is in inefficient markets. Arguably commodities is one of those areas.
RB, Watson Wyatt I think what we’re going to see 10 years from now are significantly different portfolios in the mix of alpha and beta sources. Institutions will become more demanding in trying to find returns, and then working out what it is they need to do to get them linked back to liabilities.
