Time to take the commodities plunge?

As the lustre comes off commodity prices, fund managers may want to take advantage of the weakened state of the markets. This could be the perfect time for fledgling investors to take the plunge and seasoned players to raise their asset allocation bar.

The only caveat is that the ride is expected to be much bumpier than in the recent past.

David Bird, materials analyst at Pictet, the Swiss private banking and asset management group, says "We have just come out of the longest bull market 58 months and the big question everyone wants to know is how much more will prices come down. You can still make money but sometime in the next two years, prices will dip even lower. My advice would be to proceed with extreme caution."

Ian Henderson, fund manager, JP Morgan's JPM Natural Resource fund, adds, "Volatility is inherent in the commodity market and it will not go away. Commodity markets are also more sensitive to trading swings than other financial markets because they are smaller in comparison.

For example, the entire trading market of copper is less than the market cap of Microsoft, $256.6bn, (€201.8bn). People move in and out and that will have a disproportionate impact on the prices. They don't trade like currencies which trade like water."

However, investors had been lulled into a false sense of security as prices appeared to defy gravity over the past five years, climbing to dizzying and in many cases, record heights. China seemed to single-handedly fuel demand accounting for about half of the rise in the world's consumption of aluminium, copper and steel between 2002 and 2005, and almost all of the increase in demand for lead, nickel, tin and zinc, according to figures from the International Monetary Fund.

In May, though, the party came to an abrupt halt over concerns of a US interest rate rise, and the markets have been jittery ever since. In fact, in mid-September, copper, aluminum and nickel all fell by more than 3% while zinc dropped by more than 5%.

Copper prices have been on a real roller coaster ride due to the strike at BHP Billiton Ltd's Escondida mine, the world's largest copper mine. The disruption not only halved production but caused the company to suspend deliveries to customers. The strike has just recently been resolved and shipments have resumed normally.

Meanwhile, energy, which briefly rallied in the summer in the wake of the Lebanon conflict, slid to a five month low of under $66. Gold followed suit, breaching the $600 an ounce mark for the first time in two months as traders questioned the advantage of holding bullion as a hedge against inflation if oil was heading lower.

The big fear is over the slowing down of the global economy. The International Monetary Fund does not paint a gloom and doom scenario in its just published semi-annual Global Financial Stability Report recent, but it does warn that the economic risks are greater than they were. If the cracks widen, financial markets will experience corrections more severe than the ones in May.

The IMF cites the main culprits as higher interest rates, surging oil prices and an apparent cooling in the US housing market that could put a brake to the country's economy.

There are also question marks over China. The government is trying to dampen the country's explosive growth which could impact demand for commodities. Moreover, the IMF warned that the banking system could falter if credit growth is not curtailed.

Although economic worries are a major part of the equation, analysts also note that energy prices have slipped due to reduced supply disruption. Equally as important, The Organisation of the Petroleum Exporting Countries (OPEC) agreed to maintain its current production limits at 28m barrels per day, although it plans to review the situation before the end of the year.

It is not surprising, that against this uncertain background, investors are advised to navigate their way carefully. Timing, of course, is everything and most market participants agree that finding the right moment to jump in is difficult. Bob Greer, senior vice president and real return product manager for PIMCO, the US based fixed income manager owned by Allianz, says, "For most institutional investors, the main drivers are diversification from equities and bonds, and if that is the case, once they make the decision to hold commodities, then they should start building exposure, regardless of market condition. If it is for tactical reasons, then it is a different story."

 

reer advises slow and steady tactics for fund managers taking the strategic road of diversification and alpha generation. "If it is a new investor, then they should gradually increase their commodity exposures over a year. For example, if the target is 5% of assets under allocation, then they could invest 2% to 3% now with the rest later in the year. Existing investors should follow suit. In both cases, just as with investing in general, they should choose a diversified mix of commodities to minimise risk."

Nelson Louie, portfolio manager at Credit Suisse's Asset Management business notes that "The volatility from commodities is not that much different from other asset classes such as small cap equities.

"We take a long-term strategic view towards investing in this asset class. The future prospects for commodities continue to look positive due to the continuation of the Asian growth story and long term supply constraints. Right now may be an opportune time to invest given the correction we've seen due to the lack of anticipated supply disruptions."

Adrian Jackson, an energy and mining specialist for Investec Asset Management, believes that "there could be opportunities in the oil and gas markets as the heat has come out of the prices. However, it is important to be very selective in choosing investments. We currently prefer the second tier integrated oil companies versus the ‘super-majors' because we believe that they offer better value and production growth prospects."

Daniele Tohme-Adet, head of business development of ETFs at BNP Paribas Asset Management, notes that investors are also willing to look farther a field for opportunities. Recently, the often neglected agricultural markets have come into vogue. Sugar has long been a favourite on the back of the ethanol story but wheat, corn and livestock are beginning to capture the investor's imagination.

"We expect China to follow the Japanese economic boom story in the middle of the last century. In Japan, demand started with metals and energy for construction and infrastructure projects. A large wave of urbanisation followed and a rise in living standards. This led to an increase in the consumption of beef as well as production of corn as feeder for the livestock," she says.

Investors are not only become more
adventurous in the commodities they invest in, but also in the strategies they employ. In the past, the Goldman Sachs Commodity and Dow Jones AIG Commodity indices were the favourite options.

Estimates suggest that the bulk of the $100bn that has flowed into commodities from the coffers of pensions funds and institutional investors has gone into these type of passive index funds which mimic the performance of underlying commodities.

However, as Arun Assumall, head of GSCI investor sales in Europe, notes, "The commodity markets are evolving like other markets. They start out with basic benchmarks and then other products are being developed to meet customer demand. Investors are looking at different options such as tailored made solutions, structured products and enhanced indices."

Pimco CommodityRealReturn Strategy Fund is an example of an enhanced index strategy. It uses commodity index linked derivative instruments to gain 100% exposure to the investment return of the Dow Jones AIG.

The derivatives are fully collaterised through an actively managed portfolio of inflation indexed link bonds and other fixed income securities. The goal is to capture the price return of the commodity futures market, while adding incremental return above those markets, along with additional inflation hedging.

Structured products, on the other hand, can be customised by incorporating a pension fund's specific time frame and investment characteristics. They can be built to provide a portion of the upside return of a given index or sector, while offering downside protection in case of a significant market drop.