Magazine Issues » March 2015

COMMODITIES: The raw materials for commodity investment

Cotton flowersIt is difficult to invest in commodities using the ever-popular Ucits framework. David Stevenson finds out how investors can access the asset class and whether there’s an appetite for it.

As far as Martin Estlander is concerned, commodities are an “excellent diversification instrument”. So why, the founder of Finland’s Estlander & Partners (E&P) wants to know, do retail investors who want to access this asset class face so many hurdles?

Although retail investors can invest in commodities, Estlander – whose firm launched the E&P Commodity Fund in January – is referring to the Europe’s strict diversification rules on Ucits funds that are a limiting factor for commodity investment.

Estlander structured the E&P Commodity Fund under the Alternative Investment Fund Managers Directive (AIFMD), although he points out that it offers the same investor protection that Ucits brand is famed for.

One of the major drawbacks with using funds regulated under the AIFMD to invest in commodities is that the regulation narrows the number of investors who can invest. Isabelle Bourcier, head of business development at Ossiam, an exchange-traded fund (ETF) provider, says this is the reason it was imperative that Ossiam’s commodities funds were Ucits-compliant.

“When we decided to extend our product range to commodities and discussed with a few index providers, one of the conditions we asked them was to be sure the index would be responsive to Ucits diversification rules so that we could maintain the full Ucits compliance status. For an ETF to be listed on an exchange, the Ucits tag is essential,” she says.

Commodity funds structured under AIFMD can be passported across Europe in the same way a Ucits fund can, although there are significant differences. Unlike a Ucits fund, there is no need for a daily liquidity report, though the E&P Commodity Fund does provide this on a weekly basis as well as providing estimated price information.

Regardless of the limitations for investors to enter the space, or for the ranges of strategies once in it, is now a good time for commodity investment anyway? Lately, commodity prices – most notably the oil price – have dived.

“We generally think that it’s a good time to look into commodities. Different sectors perform quite differently,” says Bernhard Wenger, head of European distribution at ETF Securities. Given that the long commodities super-cycle seems to be well and truly over, opportunities for investing in commodities now come with additional risk but also with a greater potential for reward.

Firms are now looking at the differences between commodity spot and futures prices – factors captured in futures-speak by ‘backwardation’ and ‘contango’ – which are as important as supply-and-demand factors in calculating potential returns. 

One Ucits ETF, the UBS ETF CMCI Composite, includes a broad range of commodities such as energy, agriculture and industrial metals, but is able to mitigate ‘negative roll yield’. This is caused by having to roll futures contracts where the next-month contract is more expensive than the soon-to-expire contract being sold.

According to Andrew Walsh, executive director of UBS ETFs, this product attracted $60 million (€53 million) of investment in two weeks at the beginning of February, illustrating that there is an appetite for commodity investment.

E&P’s Commodity Fund contains long and short positions and is not betting that commodity prices will appreciate. “We’re trying to find the longer-term trends, which is one part of the equation, and we’re also trying to find special situations where supply is not sufficient to meet the demand where we see price squeezes,” says Estlander.

Another way to invest would be through an exchange-traded commodity (ETC), the advantage being that anyone from a private individual to a pension fund can invest in one. Private investors’ involvement in commodities is something Steve Ruffley, chief market strategist at Intertrader, has noticed. ”You’re seeing ordinary people getting involved in oil now – it used to be traded by specialist teams around the clock,” he says, adding that he doesn’t believe this phenomenon will last long.

One the main advantages of using ETCs is that they are highly liquid. As Wenger explains, the typical commodity investor is not a buy-and-hold investor, but more tactical. The added liquidity allows investors to get in and out quickly, although it has to be said that there is an underlying risk in using these tools. They don’t have the investor protection assigned to other products – which means, according to Walsh, that you could lose a lot of money.

There is a distinct lack of competition in the commodity space at the moment; investors and investment banks are exiting. Banks are under regulatory pressure to maintain capital requirements and some would argue that investment banks didn’t really have large commodity trading desks anyway. Yet for those left in the game, it appears to be a favourable marketplace. 

Estlander believes he has timed the entrance of the E&P Commodity Fund well, as he thinks there has been a change in market behaviour with a move away from central bank influence.

“Now the market has got out of this sense of being manipulated by the central banks, the markets are acting like they used to do in the past, managing money using long volatility. Markets are moving again, which is as important as it is for any other asset class,” he says. 

Estlander also believes that the futures market, where his fund is exclusively focused, is behaving more like it did before the financial crisis. He says the potential for harvesting returns is better because the futures curves of different commodities are at good levels. The fund is structured to take advantage whether the futures curve is in contango or backwardation.

The oil price has crashed by an incredible 50% since summer last year. Commodities bull Jim Rogers, co-founder of the Quantum hedge fund, is reported to have conceded that he did not expect the commodity meltdown, though he still believes markets are in a long commodities rally. There are some for whom commodities will always play a part in their investment strategy. As an asset class, it is known for being counter-cyclical. But with the global economy in good shape and a strong dollar helping to keep oil low, commodities are trading counter to an equities bull market. As Rogers famously said: “Commodities tend to zig when equity markets zag.” 

Having commodities in an investment portfolio has for decades been a diversification option. Despite there being some Ucits funds that are involved in commodities, last year’s guidance to Ucits managed by commodity trading advisors – to be sufficiently diversified, fully transparent and easily replicated – stopped some funds in their tracks. Cantab Capital Partners shut down its Ucits-compliant $320 million CCP Quantitative fund in response. 

With alternative investment fund managers not being subject to leverage and liquidity restrictions, they can transact in more esoteric instruments and ways. Once commodities pick up, investors might expect a deluge of funds structured under AIFMD to hit the market.

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