According to economists Bilge Erten and José Antonio Ocampo, under their hypothesis it is possible to identify three non-oil super-cycle periods during the past century with amplitudes of 20-40% higher or lower than the long-run trend, with a fourth starting in early 2000 and still ongoing.
Boom in demand
The last commodity price boom was outrageous, with energy and metals doubling their real prices in five years from 2003 and 2008 while food commodity prices increased 75%. As we are aware, this increase has been driven by an unprecedented boost in the demand for commodities from the major developing countries, particularly from China.
These emerging countries have sharply boosted their investment in industrial development, with infrastructure and urbanisation further increasing demand. Nevertheless, this cycle has been fuelled too by cheap money and the increasing dominance of financial speculators through the use of commodity indices.
One of the easiest ways to invest in the emerging market countries’ bonanza was through commodities, either physical (e.g. ETFs) or equities. Therefore, besides the pure fundamental price factors of supply and demand, there are other topics – money flows, for example – that might have affected the commodities’ price behaviour. Likewise countries like China increased their currency reserves in real assets, piling stocks of raw material in their warehouses due to the uncertainty in the currency and bond markets.
It is worth mentioning several findings regarding the current commodity environment that most macro fund managers have pinpointed:
• The worldwide extended fiscal stimuli are urging non-long term investors to look for compelling investments. It cannot last forever and eventually money will rush out from this arena, maybe leaving a desolate landscape for at least the short term;
• The need for infrastructure and urbanisation, according to most of the macro managers, will remain in most of the emerging market countries but will progressively recede and the demand will be more oriented towards consumption. Commodities such as energy and agriculture will keep their attractiveness in the long run as the lifestyle in these areas will evolve;
• There are strategic and long-term policies affecting and distorting the open markets as producers and consumers start to be aware of the relevance of their own natural resources as a way to counterbalance their lack of representation in the world – and of course, to gather more money. The resurgence of nationalism, the need to hold strategic reserves and keep natural resources independent will be mainstream issues in the coming years;
• The regulation in some economic areas is becoming more stringent about commodity investing kicking out some investors in order to ‘protect’ other investors’ interests. Agriculture commodities are one of the most controversial topics and they have been banned by some fund houses due to the potential reputational issues.
According to several market researchers, we cannot expect any strong trend across all the commodities. However, we can on an individual commodity basis, thanks to trends such as consumption behaviour and technology changes.
However, on a portfolio construction basis according to most of the asset allocators, this asset class plays an important role in several aspects:
• Diversification – the relationship between commodities and equities is gradually normalising, being influenced more by supply/demand issues and less by financial flows;
• Inflation hedge – commodities can play an important role on the inflation protection side, should this price increase be demand driven;
• Event risk hedge – some commodities, such as energy, can work as a geopolitical event hedge, at least in the short term as prices are affected more by supply.
Choices to make
If you are positive on the commodities super-cycle story, the most common way to have exposure is through sector equities. Commodity prices have a role in the stock price but we are also aware that commodity stocks are also affected by equity market behaviour. Therefore it does not keep some of the main features of the commodities themselves within the portfolio construction process (diversification or inflation hedge). The flip side is that it produces yields that the physical holding does not produce by itself in all the commodities.
Investing in physical commodities through futures can be frustrating and time consuming, mainly due to the futures rolling. Hence financial commodity indices/funds are good alternatives and provide diversification for most of the investors.
Although there are some potential regulatory issues affecting the current use of commodities within a Ucits framework, most of the fund managers are likely to be able to adapt themselves to the regulation.
The middle path
There is a third way, commonly used by macro managers, that is via currencies playing the imbalances in the current account of some commodity-producing countries, but they have also embedded other risk factors that can distort the behaviour.
Within this category we can think of gold bullion as a currency as its behaviour is not only driven by supply and demand issues but also by other economic factors (dollar, inflation, etc).
According to our internal methodology, it is possible to split the physical commodity funds’ peer group into several sub-peer groups according to their tracking error, correlation and philosophy. Therefore we have index funds, enhanced index, active beta funds and long/short funds, including those that are market neutral.
One of the most common enhancements in most of the funds relates to the rolling of contracts. Instead of doing it between the first and the second contract, they are allowed to go beyond them to avoid the negative carry from the contango shape.
Also, the choice of the index will affect the weight in different commodities but the most commonly used is the DJ UBS Commodity TR Index. UBS and Credit Suisse index funds, among others, are ones that are pegged to the reference indices. There are also houses – such as Credit Suisse Glencore, Pioneer or Threadneedle – that actively manage the allocation towards commodities depending on their tactical view.
Other houses provide enhancements in their indices through collateral management, like PIMCO. Also there are a few long/short commodity funds such as the one run by Deustche Bank.
However, if you still think the commodity cycle is fully over and it has to be actively managed, why not invest in asset allocators/macro fund managers? There are plenty of them out there: Newton, Standard Life, Invesco, Aquila… It is up to you.
So, even though the current boom in commodity prices might be over, commodities as an asset class within a portfolio are crucial to provide proper diversification and some hedging against events and inflation.