The Case For Investing In Commodities
By: Michel Jalbert & Patrick Thillou
Hardly a day goes by without a headline about another commodity price setting a new record high. The bullish outlook for commodities over the next decade or more is based on an anticipated increase in consumption from China. But, developing regions like Brazil, India, and Russia have many experts believing future demand for commodities will be more global in scope.
Todayʼs pension plan sponsors are considering what role commodities might play in their portfolios for the long term. Historically, commodity prices have exhibited little or negative correlation to equity and bond prices, but they have been positively correlated to inflation. Thatʼs what makes commodities so appealing.
What Are Commodities?
A commodity is defined as a good that may be sold or bartered. Generally speaking, any tangible good can be categorized as a commodity. A commodity is typically a bulk good such as gold, silver, natural gas and oil, or a bulk food product like grain, oats, corn, beef, pork bellies, and coffee. In the original and simplified sense, commodities were items or goods of value, of uniform quality, that were produced in large quantities by many different producers. Wheat and other commodities are generally pooled for sale as there is a uniform standard of quality. Commodities are traded at a commodity exchange that not only facilitates the commodity trade, but also establishes and enforces rules and regulations pertaining to the commodity trading process.
Historically, dating from ancient Sumeria, people have sought ways to render the trade of commodities more efficient. Classical civilizations built complex markets for trading gold, silver, spices, cloth, and wood, most of which had standards of quality and timeliness. Considering the many hazards of climate, piracy, theft, and abuse by rulers of kingdoms along the trade routes, trading in these scarce commodities was a risk. People started speculating on the supply and demand for the commodities based on whether the commodities could weather the hazards. This is not unlike the trade in commodity futures as we know it today.
Today, a commodity future is an investment vehicle. It is based on an agreement to buy now and deliver later at a price determined today. The commodity futureʼs value is based on the price of the underlying commodity, the cost of storage, and the time to maturity. Historically, in an attempt to hedge their production costs, producers have been willing to offer a discount to buyers who wanted to be at the long end of the transaction. Consequently, the total return on the commodity-related futures has been much greater than the increase in the spot price of underlying commodities. According to our analysis of data between January 1970 and June 2006, the annualized cumulative return on underlying commodities was 4.4 per cent while the annualized cumulative return in the same period for the Goldman Sachs Commodity Index (GSCI)1 was 12.3 per cent.
What Can Commodities Add To A Pension Plan Portfolio?
We often hear that investing in commodities is risky, but the opposite might be true, especially if commodities are part of a diversified investment strategy that includes traditional asset classes. Between 1959 and 2004, commodity futures offered the same return and Sharpe ratio as U.S. equities, according to research done by Professor Gary Gorton, of the University of Pennsylvaniaʼs Wharton School, and Professor K. Geert Rouwenhorst, of the Yale School of Management, for the National Bureau of Economic Research, or NBER (Facts and Fantasies about Commodity Futures, June 2004).
Commodities often move independently of financial markets. During the 1970s, commodity futures outperformed U.S. stocks. During the 1980s, the exact opposite was true – evidence of the negative correlation between stocks and commodities that many have noticed. While bear markets in stocks are often accompanied by bull markets in commodities, the returns on commodity futures in the NBER study were positively correlated with U.S. inflation. Thatʼs because higher commodity prices are the leading edge of high prices in general, resulting in better commodity returns, and poorer stock and bond returns, in inflationary times.
While investing in the stock of commodity producers is one way to play a commodity bull market, it is not necessarily the best way. Between 1962 and 2003, the cumulative returns of commodity futures examined in the NBER study were higher than the cumulative returns of an equivalent investment in companies that produced those same commodities. Many factors influence their stock prices besides the commodity price including interest rates and risk premium, as well as company- specific factors such as exploration success, political risk, and management. Moreover, investing in the stock of commodity producers does not generate the diversification since those securities demonstrate a higher correlation with the overall stock market.
The main reason pension plans would want to add commodities to their portfolios is for diversification. If you look at the correlation of commodities with most traditional asset classes, the returns are divergent. Our research shows that, in rolling one-year returns from January 1984 to December 2005, the GSCI had a negative correlation with Canadian bonds, U.S. equities, and EAFE equities. Because the Canadian equity market is commodity heavy, our research also shows that the GSCI had a slight positive correlation of 28 per cent with the S&P/TSX Index in that same period. However, as shown in Graph 1, commodities have tended to produce positive returns in periods where the Canadian equity markets performed the worst.
Commodity prices are volatile, but not much more so than stock prices. We believe that if you decide to invest in commodities, it is important that you have exposure to a diversified basket of commodities. Each commodity by itself might be volatile because it has its own supply and demand dynamic. When you combine the commodities, the overall volatility actually decreases, as you can see in Graph 2.
Commodities have also offered some protection against the effects of inflation. The price of the commodity investment vehicle, generally a futures contract, goes up with the price of the underlying commodity. Historically, the price of the underlying commodities has grown with the worldʼs economy as measured by global GDP. Assuming that the supply/demand dynamics for commodity future contracts remains approximately the same, a broadly diversified basket of commodity futures should, in the long run, return at least six per cent to seven per cent annually, which is significantly better than the top end of the Bank of Canadaʼs inflation target of three per cent. That leaves a very attractive net real rate of return of three per cent to four per cent.
How Should Sponsors Be Using Commodities?
Assets are piling into commodity-linked indexes. According to a Barclays Capital report quoted by Bloomberg in January 2006, the amount of money in funds tracking commodity indexes rose in 2005 by almost US$30 billion to about US$80 billion. Bloomberg also reported that Morgan Stanley expects this figure to rise to US$140 billion by 2010.
The alternatives to investing in commodity- linked indexes are not very appealing. Indeed, it is not very convenient to buy the physical commodities because there is no advantage in owning boxcars full of soybeans or pork bellies once the issue of storage and liquidity arises.
You can always buy shares in the producers of the commodities or related corporations. But then you lose that disparity in correlation with the equity market that allows for the diversity. It is also difficult to identify a set of publicly traded companies that could serve as a good proxy for the basket of commodities covered by the futures index because many producers are part of larger conglomerates.
Another alternative is to buy Exchange Traded Funds, but their fees are typically higher than what most institutional investors are willing to pay.
Using a passive approach and getting the beta of the market is, in our opinion, preferable to investing in a commodity hedge fund where there is more risk and volatility stemming from the short and long calls. By focusing on delivering absolute returns and not replicating an index, you might also lose the diversification effect by investing in a hedge fund.
The most critical decision to make when investing in commodities is to select an index that best suits a pension planʼs objectives. We chose the Goldman Sachs Light Energy Index for the CIBC Pooled Commodity Fund. This index invests in 24 major commodities and has a lower exposure to the energy sector than the standard commodity index. In todayʼs environment, energy is the commodity that carries a lot of political risk and is subject to large variations in price. As a result, a pension plan interested in stable returns would want to control the influence of energy on the portfolio.
The Goldman Sachs Light Energy Index also provides better diversification, good liquidity, low cost of replication, and suitability for the Canadian-based investor who is already exposed to the energy and materials sectors through domestic stocks.
The Goldman Sachs Light Energy Index is the same as the broader GSCI, except that the energy sector has been reduced and the weights of the other commodities are relatively increased. As a result, although it contains all the commodities included in the GSCI, they are not world-production weighted in the same manner as the GSCI.
Commodities are a strategic allocation to the portfolio. The amount to invest in commodities depends on the proportion of the underlying plan liabilities linked to inflation. Generally, this allocation would vary between five per cent and 10 per cent. To guard against the ups and downs of market timing, we recommend investing incrementally rather than investing all at once. It might also be advisable to combine commodities with other inflation hedging investments such as inflation-linked bonds and real estate.
Which Sponsors Should Be Considering Commodities?
Any plan sponsor which has its liabilities linked to inflation should certainly be considering commodities. This would apply to any Defined Benefit plan that typically provides for increases in the cost of living. As well, any plan sponsors who want to stabilize their returns over the years would benefit from the diversification effect of commodity exposure.
Some Canadian pension plans have already established an allocation to commodities. According to Toronto-based Integrated Asset Management Corp., GM Canada has a 10 per cent allocation, Laval University seven per cent, and Caisse de Dépôt et Placement has allocated an initial one per cent with a commitment to increase it. Ontario Teachersʼ Pension Plan currently has three per cent, or $2.6 billion, allocated to commodities. In 2005, the Teachersʼ return on its commodity exposure was 21.6 per cent.
Investing in commodities makes sense for Canadian pension plans, but it is critical to choose a product or vehicle that offers a diversified exposure to commodities. Moreover, it makes sense to apply a gradual and staggered strategy when adding this asset class to a portfolio.
Michel Jalbert is vice-president – consultant relations, and Patrick Thillou is vicepresident – quantitative and structured products, at CIBC Asset Management. 1. (Copyright 2006. Goldman, Sachs & Co. All rights reserved.)
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