September 2011

COMMODITIES: Raw material considerations

STEEL-YENInvesting in commodities can protect against wars and supply shocks while cashing in on emerging market growth. But the asset class is blamed for worsening hunger in the Third World, finds George Mitton.
Chinese production of crude steel has grown five times over in a decade and now accounts for nearly half the world’s supply. Steel underlies the country’s phenomenal growth – it is the silver skeleton supporting China’s railways, skyscrapers and shopping malls. In the same period, the price of coking coal – essential for making steel – has risen from $40 (e28) a ton to $170. It doesn't take a genius to spy an opportunity here. Rapid growth in China and other emerging markets is putting increasing pressure on limited supplies of commodities like iron ore and coking coal and forcing up prices. These countries are also adding to unprecedented demand for industrial metals, grains, foodstuffs and fertiliser. As global stock prices undergo dramatic volatility, is now the time (again) to invest in commodities? There is already considerable momentum behind this asset class. Total assets in commodity ETPs (exchange-traded products), which aim to track commodity prices, have tripled in the past three years to $171bn by the end of June 2011, according to ETF Securities. And this is just one of several ways to gain exposure to commodities. Investors can also buy stocks in firms that produce commodities, invest directly in futures contracts or pay managers to buy futures for them. There are many reasons to like commodities. They are relatively uncorrelated with other asset classes, meaning they are a good diversifier. They offer a built-in hedge against inflation, provided investors spread their money across a basket of commodities. They can protect equity portfolios against political turmoil and natural disasters that limit the supply of raw materials. (This was not the case with the Japanese tsunami.) “You have event risk protection,” explains Colin O’Shea, head of commodities at Hermes Fund Managers. “Events such as wars or oil shocks are positive for commodities and negative for equities.” The returns, too, have been impressive with commodities outperforming equities over the last ten years. They are also highly liquid, unlike other alternative asset classes such as private equity or infrastructure which have long lock-in periods. Slow on the uptake
Given the benefits of commodity investing, it is perhaps surprising that the proportion of institutional investors taking part is still fairly low. O’Shea says commodities are “massively underrepresented in pension scheme portfolios”, a claim seemingly confirmed by figures from consultancy Mercer, which says only 7.5% of European schemes have a specific allocation to commodities. Some European schemes have been more active, such as the Dutch and the Swiss. But even these schemes could drastically increase their typical allocations from current levels of between 3% and 5%, says O’Shea. If a scheme has large equity and bond holdings and is not well diversified, it should consider allocations of between 10% and 15%, he claims. Pension schemes can be forgiven for being slow to this asset class, however. Amid the benefits, there is an important snag, which is that commodities are highly risky. “The volatility of commodities is greater than equities,” admits O’Shea. Investing can be perilous because the prices of similar materials can diverge sharply. The S&P industrial metals index has fallen nearly 8% between January and August, while S&P’s precious metals index has soared more than 23%, for instance. The problem is that prices are at the mercy of exogenous or hard-to-predict events. The Japanese earthquake caused commodity prices to tumble as the country’s demand for raw materials suddenly dropped. Nevertheless, managers insist their bets can make their clients’ money. Jonathan Blake, who runs the Baring Global Resources fund, is bullish about copper, which is often considered a bellwether of industrial activity. “Our expectation is now China has begun to get its inflation under control, we might see some loosening of monetary policy towards the end of this year,” he says. “If that’s the case, it’s likely we'll see China begin to restock inventories of copper.” He is also keen on precious metals as these make a reliable investment when inflation is higher than interest rates. The preeminence of gold confirms this point. The price has increased by nearly half in a year as investors around the world – particularly central banks in emerging markets – pump money into gold funds and ETFs. Blake is also keen on agricultural and other “soft” commodities such as corn, wheat and soybeans. Hot weather in the US has reduced crop yields at the same time as food demand rises in the emerging world and biofuels take a greater proportion of corn off the market. These factors will increase the price of grain as well as the price of fertiliser, which producers will buy to boost yield from their crops. However, this raises another thorny problem with commodities investing, which is its perceived link with high food prices and poverty. Between June 2005 and June 2008, the price of maize nearly tripled, rice grew 170% and wheat 127%. Though prices fell after the financial crisis they have now returned to their 2008 high. These changes are felt disproportionately hard by the poor. A doubling of wheat prices may add a few pence to the price of a pre-packed sandwich in the West, but it means a doubling of the cost of bread for those who make their own from flour. Because it is thought to contribute to high food prices, Michel Barnier, the European commissioner for internal market and services, declared in January that speculation in agricultural commodities is “scandalous”. He is not alone in seeing a connection. Michael W Masters of hedge fund Masters Capital Management told a US Congressional committee in June 2008: “You have asked the question ‘Are institutional investors contributing to food and energy price inflation?’ And my unequivocal answer is ‘yes’.” Though research on the subject is inconclusive, fund managers often have to defend themselves against claims they are pushing up food prices. Blake accepts speculators have an impact but argues they can have a positive role. Market fundamentals
“The investment community is … very much part and parcel of the price discovery mechanism within soft commodities,” he says. “Clearly there can be a magnification effect as investment flows come into or out of soft commodities … [but] one should acknowledge that speculators do provide liquidity in commodity markets as well.” O’Shea, of Hermes, who also invests in agricultural commodities, accepts that speculators can affect food prices “over a one- or two-day time period”, but argues that market fundamentals determine prices over a few weeks. “By buying paper corn or paper soybeans, you’re not taking any physical corn or beans off the marketplace,” he says. “What’s driving the corn and beans market is fundamental supply and demand.” Unless the perceived link between speculation and starvation finally causes commodity investors to shrink from the bad publicity it generates, they are likely instead to increase their investments. There is plenty of room to do this still, because although ETF Securities data shows a tripling of commodity ETPs, these assets “remain small relative to the ETPs tracking other asset classes (around $1.5 trillion), indicating there is substantial room available for further long-term growth”. As demand for diversifying assets increases, this growth may come. However, the challenge will be to convince institutional investors that the risks and volatility are worth bearing. ©2011 funds europe

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