Are institutional investors returning to commodities?
It was a bumpy ride for commodity prices between 2014 and 2016, a result of their close correlation to the state of the global economy.
In particular, 2015 saw a major downward trend in many of the more frequently traded commodities, such as corn, gold, lead, silver, soy and wheat, with iron ore, natural gas and oil the worst offenders.
As a result, investors haven’t been particularly hungry for them in the past few years, according to David Chang, a senior managing director and commodities portfolio manager at Wellington Management Co. “Very few investors have rebalanced into the asset class, despite their attractive relative valuations and a positive roll yield for many critical commodities,” he says.
Where investors are turning their attention back to commodities, how are they seeking exposure?
Pension funds aren’t expecting commodities to be the fuel that drives asset growth, says Toby Goodworth, managing director and head of risk and diversifying strategies at bfinance Inc. But they’re still worth including because they’re largely decorrelated from most other asset classes, he notes. “From our side of things, the multi-asset approach, the principal argument for its inclusion is diversification.”
Indeed, the majority of Goodworth’s clients access commodities “in a multi-strategy, absolute return format, or in a relative value, risk-premia-style format,” he says. “There, commodities are recognized as one of the four core asset classes alongside equities, fixed income and currency. And generally, because of the elevated volatility, they are one of the minor allocations.”
Alone, commodities don’t represent an attractive risk-adjusted return, says Goodworth, but they have a role to play as part of an ensemble. “The power of those strategies really begins when you begin to combine them, because they’re all mutually independent. You begin to increment your Sharpe ratio by adding lots of incremental Sharpe ratio strategies. So the power is that it’s a differentiated return stream and it can help add value as part of a broad multi-asset strategy.”
Chang says the simplest way to gain direct exposure to commodities without having to necessarily deal with physical assets is through derivatives trading. “Pension plans are typically looking to commodities to serve as an inflation hedge and diversifier,” he says. “Futures have historically offered the highest inflation sensitivity and lowest correlations with traditional assets.”
Whether or not a pension fund is seeking direct exposure to a specific commodity or sector, it’s likely considering commodities when making allocations to other asset classes, says Ryan Kuruliak, senior vice-president at Proteus Performance Management Inc.
“A Canadian plan, even a big one, might not want any more exposure to oil than it already has through its equity holdings,” he says.
As well, there are evident links for more tangible assets, such as real estate and infrastructure. Agricultural land, for example, is becoming a popular, fixed income-like asset for many plans, according to Peter Hobbs, managing director of private markets at bfinance.
“Within agriculture, you can enter a sort of a leasing strategy where you can provide leases to farmers, to different types, over different lengths of time. And it’s much more bond-type,” he says.
While this way of investing is insulated from the price volatility of particular crops grown by agricultural tenants, pension funds can gain more direct exposure through private equity allocations, says Hobbs. However, he warns that private ownership may raise the level of exposure to operational costs and pricing volatility risks.
COMMODITIES IN THE BALANCE
A 2018 survey by Natixis Investment Managers’ Center for Investor Insight looked at how global institutional investors are balancing their long-term objectives with short-term opportunities and pressures.
Where respondents favoured diversification, 47% cited global macro strategies, 41% cited commodities and 40% cited infrastructure. Where they preferred inflation hedging strategies, 56% chose commodities and 46% cited real estate.
“That is a challenge with these discussions, but also the opportunity is that they can provide both ends of the spectrum.”
Long-term views on commodities can affect the viability of any given real asset allocation, says Hobbs. “There is huge uncertainty there because of technology, in particular, changing the demand for different commodities or different types of infrastructure. So often you’ll find in infrastructure or agriculture, you might have a lot of security over the, say, five- to 10-year income stream. But what happens after 10 to 15 years, when the world is a very different place?”
There’s little consensus on the long-term paths for commodities, so reaching these types of decisions is a major challenge for investors, he adds.
The Canada Pension Plan Investment Board doesn’t seek out direct exposure to commodities as part of its long-term strategic asset allocation, but it’s keenly aware of the exposure it does have through other channels, especially real assets, says Aleksander Weiler, managing director and head of strategic tilting at the pension fund.
“Our bigger, direct investments in companies that have a direct business in commodities sit in our real assets group and that’s a mix between real estate, infrastructure and private equities.”
For example, the CPPIB holds two large European pipeline investments, both funnelling natural gas from providers to utility companies. As well, its natural resources group holds a stake in a company that provides grain elevator infrastructure. “We didn’t seek an investment in an agriculture company specifically, but we thought it was a good investment and it happens to have a component of agriculture underlying it,” says Weiler.
As for long-term assumptions on the continued viability of any particular commodity, Weiler says there’s no set house view at the CPPIB, but he does point to the standalone power and renewables group it formed in 2017.
“The fact that we created this group tells you that we think this has the potential for very interesting returns longer term,” he says. “And we don’t create groups lightly, so that has been a very notable development for us.”
When investors consider real assets, environmental and social issues come into play. Many endowment funds, for example, are shunning exposure to fossil fuels for environmental reasons, says Kuruliak. Pension plans are also trying to more fully wrap their heads around the risk-to-return ratio any given commodity may represent, he adds.
On the societal side, issues arise around agricultural commodity trading, according to Jeremy Gatto, investment manager for Unigestion’s multi-asset navigator fund. He says his firm avoids investing in the area entirely in order to avoid the speculation and volatility that could have a negative impact on farmers and populations with food insecurity.
Chang, however, says his firm takes the opposite position. “Some pensions have expressed the view that investing in certain commodities such as agriculture can accentuate price volatility and at times inflate prices for consumers. Yet, we don’t believe this to be the case,” he says.
“Importantly, we believe the futures market improves liquidity and sends signals to the market to adjust supply or demand during times of stress. In a period where prices are well above production costs, the signal is sent to producers to increase their production and supply. Ultimately, we believe these market signals can mitigate the risk of food shortages and help prices revert back to their long-term equilibrium level.”
Even directly, institutional investors can do social good where commodities are concerned, says Hobbs. One of his client’s investment in a Latin American blueberry farm allowed it to advance operations, specifically enabling the farm to freeze its produce. This led to the farm operating more efficiently and drove up local wealth in the area, he says.
“I think managers are thinking very broadly about ESG,” says Hobbs. “It’s not just trying to use it to improve productivity and improve performance but also help the well-being of the people working on the farms and so on.”
Martha Porado is an associate editor at Benefits Canada.
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