Commodities debate: Refining value from raw materials

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FW, PGGM Well, in Q3 2007, we started to analyse our benchmark in commodities. We do this every two to three years, but the main reason was the huge contango [upward sloping forward curve] in the market in 2006. The first question we asked was: "Is commodities still a viable asset class within a multi-asset portfolio?" The second was: "Given an investment in commodities, what should the weighting in energy be?" We were worried about the higher weighting in energy that we had in our benchmark. We were 60% GCI, 40% sub-energy index, so roughly 82% energy exposure. So we set out the reasons why we were invested in commodities. These were, in order of priority: diversification, a hedge against geopolitical risk and – much less important – as a possible inflation hedge. When we did this review in 1999, we used very prudent measures: low expected returns and a very high negative correlation with other assets. This time around we used a zero correlation to other assets and a higher expected return. Even with those different parameters the conclusion was the same: commodities are still a viable asset class for diversification reasons in a multi-asset portfolio. In fact we decided to increase our allocation to commodities from 5% to 7%. And we found that the high energy weighting gives the best diversification within the overall portfolio, so we still have that and we increased our allocation to 7%. So yes, commodities is still a good asset class for diversification reasons.

DM, NFC If by "investing in commodities" you mean "going long commodities", I tend to take a slightly more sceptical view than average. I’ve never been completely persuaded by the diversification argument but I think, seeing today’s geopolitics, that one has to think that commodities have a place in a portfolio as a small allocation. The investors I meet seem to be a little too enthused by the recent returns in commodities and are probably not taking the rigorous approach taken by PGGM. I am deeply concerned by the volume of money flowing into some of these markets. If you see the quality of commentary on some of the events that occurred in March, it was very low, and so I would urge investors to be careful. The flows into some of the agricultural markets is an example: there is a strong possibility people will see substantial retracement on any attempt to liquidate this new open interest. With respect to other types of commodity investment, such as investments in hedge funds or trade commodities or trading strategies, they’ve not had an outstanding last year, but I think the possibilities within that arena are excellent as a source of absolute return, and I think investors must also look at the absolute return possibilities in commodity markets.

BG, Pimco I think there are two issues. One is the flows, and we are coming to that later. The original question was: "Is it still a good idea to invest in commodities?" Defining commodities as investing in some form of long-only exposure, as benchmarked by an index, the answer is: "Yes, it is still a good idea." I am convinced that commodities will provide diversification over a strategic time frame from stocks and bonds. There are a lot of fundamental arguments that say that commodities should – and we have a history of 45 years showing that commodities have – provided that diversification. So with both economic logic and extensive history on our side, yes, for diversification reasons it is still a good idea.

RB, Watson Wyatt So, for diversification, but not necessarily for returns?

BG, Pimco I do not project the actual cash price of commodities, because all of this institutional investment is not in the ownership of commodities, it is in some form of index exposure. And Paul, I’m not referring to the type of activity that you do with your more hedge fund products, I am talking about indices as a measure of the asset class, and those inherent returns include the Keynesian risk premium, they include convenience yield, they include rebalancing, if one chooses to rebalance, all of which are on top of the base return on collateral, and again we have our choice of what collateral that would be. So you ask about projecting returns; I will use history as a guide for those various components of the commodity return and we, of course, need to project what the return of the collateral will be. You add it up and then you reduce that number, because in fact the diversification argument is so strong that even with projecting numbers much lower than historical, you still find that most asset allocation models want more commodities than a chief investment officer would really dare to put into his or her portfolio.

SB, Euromoney How many investors view commodities as an inflation or diversification overlay product and how many are seeking alpha or absolute return?

BG, Pimco The bulk of the $150 billion to $200 billion are looking for diversification and, to a much lesser extent, the inflation protection of the asset class. The money that is looking for absolute returns is either going to be in a totally actively managed hedge fund, or it’s going to be short-term money that says: "I think commodities as an asset class are going up over the next several months." The fact that the money stayed in index funds and with the institutional accounts, even during periods of downturn in commodity and commodity indices, demonstrates that more of the money is looking for those longer-term benefits.