Wikinvest Wire

Commodities: A "Cinderalla Story"

Tuesday, July 07, 2009

With the price of oil now plummeting - just $62 a barrel as this is written - the commodity bulls of the world may need some "positive reinforcement" regarding the longer-term picture for this asset class and the Financial Times is happy to supply such in this report.

Commodities: Cinderella class slowly gains allure
The world of commodities, encompassing everything from gold to pork bellies, emerges as a real Cinderella asset class in the Watson Wyatt survey. Of the $872bn (£527bn, €621bn) held in alternative assets on behalf of pension funds by the 100 largest managers, a meagre 0.4 per cent resides in commodities.

David Hoile, head of asset research at Watson Wyatt, believes the asset class is not quite as unloved an ugly sister as it first appears; the survey only picks up direct exposure to commodities, whereas many pension funds will also have exposure via vehicles such as multi-strategy and global macro hedge funds.

“Pension funds are likely to have a 5-10 per cent allocation to commodities,” says Mr Hoile, with North American funds much keener than their European counterparts. A slice of funds’ equity allocation will also be in commodity-related stocks, providing another element of exposure.

The low allocations are, in part, simply a result of history; commodities are a newer asset class than, for example, real estate or private equity.
It is notable that, with all the hand-wringing over endowment fund losses and the many asset allocation changes that resulted, there seems to be an almost unwavering commitment to the natural resource sector in general and commodities in particular.

Of course, upcoming changes to the regulatory environment and tarnish on the Goldman Sachs/JP Morgan stars may change all that.

I'll never forget an email I received about a year ago, something to the effect of, "I have been on the Street for 20 years and I know to stay away from commodities".

Well, that's changing, despite the protestations by some that it is not a real asset class.
Philippe Comer, head of commodity investor solutions for the Americas at Barclays Capital, says it is only in the past decade that financial investors have entered a market still dominated by the producers and consumers of commodities.

Mr Hoile adds: “The financialisation of commodities by institutional funds was something we only really started to see from 2001-02. The modest allocation currently reflects that fact that we are at the start of a trend.” But there are also deeper forces at play that even a particularly benevolent fairy godmother would struggle to wish away; both the rationale for investing in commodities, and the mechanics of how any exposure should be generated, are questions still up for debate.

Mr Comer reports that institutional interest has been driven by a desire to increase diversification and to hedge against the risk of higher inflation.
There's much more in this very good piece on historical cycles, the difficulties with yield roll, active management, and a number of other topics.

One of the big differences between the 1970s and today is that, back then, the returns on commodity investments also benefited from high interest rates as most investor money was directed toward fixed income investments, futures contracts typically costing 10 percent or less of the face value of a futures contract.

With today's freakishly low interest rates, that works against investors.

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Anonymous said...

The problem with most commodities is that they depend upon futures bases vehicles. That is, the people on the other side of the trade must be willing and able to take horrendous losses to pay off on the futures contracts if prices move a lot. What is the chance that this will happen? They may just declare bankruptcy like Lehman did, and the futures would be virtually worthless.

The super contango recently in oil may be a measure of the high risk premium being now charged by the people on the other side of the trade. A limited number of people could rent tankers and store oil, but not enough for oil futures to be covered in general.

Futures are not likely to produce historical returns once they become ubiquitous vehicles. Few have enough money to pay off on the bet if the price goes against them. Many of these contracts are just AIG type offering of useless bond insurance. AIG did not have anywhere near enough money to pay off the mortgage bond futures insurance they issued.

Who will bail out commodity futures traders who issue contracts they cannot pay off on?

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