Well, what is an investment in commodities? Why does it seem to be flavour of the month? Certainly, if it is an investment in say the Goldman Sachs Commodities Index it is not necessarily an investment in commodity Prices. When looking at a commodity index investment one must look at other things and perhaps most importantly the shape of the Forward Curve. If one believes that the normal state of the forward curve allows you to buy forward contracts at a price below the current price then an investor will make money. Backwardation is the technical term but for quite long periods the curve may not be in backwardation but reversed in what is described as Contango.
So if an investment in commodities is not an investment in commodity prices why has so much more money been made over the last few years when basic prices have been rising? Good question and if prices don’t continue to rise as they have, will pension fund investors in the sector suffer? Quite possibly or certainly say the sceptics.
It is certainly true that early investors in the sector such as PGGM in the Netherlands have made buckets of money but ironically they didn’t invest in the sector expecting the returns they have received. They and other long term commodity investors did it because historical commodity index returns appear to be entirely uncorrelated to returns in bonds and equalities the two main pension fund sectors.
The further irony might be that those funds that follow PGGM into commodities expecting a continuation of the big returns are likely to be disappointed although, of course, they might indeed still see diversification. However, whether funds want diversification if it means lower returns is another matter.
However, there are still hopes that investors will continue to achieve good returns but some Strategists such as Frank Veneroso from Allianz RCM are very concerned about the wall of money moving into commodities and argue that pension fund money could distort the market. In fact the more money goes into commodities the more we are likely to head for disaster. Pension funds in total are simply too big for the commodities
marketplace. Whereas most pension funds feel they can take comfort if lots of people do the same thing at the same time, it is probably the worst thing that can happen.
The traditional argument might run along the lines that there are two phases in the commodity cycle where big returns are made. We are possibly at
the end of the first phase when returns have been generated from big price rises. The next phase will see volatility and for the careful investor that should provide the opportunity to produce significant returns.
First of course, you have to believe the current commodity prices are reasonable. Whilst we can talk about commodity prices in general it is really the price of oil that matters most. Oil dominates the commodity price index. In theory changes in long-dated oil prices coincide with changes in the marginal cost of production. This supports long-dated prices. Are we running out of oil, probably not but producer costs have increased, transportation costs have increased, all the easily located oil may have been found so inevitably the long-dated price has increased but to over $50/bbI?

What is the impact of speculators? Is there a wall of money coming into the sector? Will this distort prices? What about other commodities, I am told that some metals are now at critically low levels and that global wheat production cannot be expanded to meet current demand and that agriculture demand is tied to economic expansion but that the US is not investing in production, for example US cattle inventories are expected to decline to the lowest levels since the 1960s. But I still get a little frightened at the prices some commentators talk about.
So I would argue that if pension funds want to invest in commodities they should do so only because they see the benefits of diversification and that might mean prolonged periods of underperformance. If the historical correlation coefficients of the GSCI Commodity Total Return Index with equities, bonds and real estate is low or negative then that must mean poor returns when (or if) we see good equity or bond performance. However, there is little doubt that if we add a 5% or even 10% exposure to commodities to a typical balanced European pension fund portfolio we are likely to increase expected return and reduce risk on most reasonable assumptions. Let’s face it, for most pension funds it is their equity exposure that contributes the substantial majority or risk and return and that manager choice contributes only a small proportion to risk control or the likelihood of enhanced return. Asset allocation may not be everything but I believe it is the major decision that funds need to get right.

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