Greater returns on varied exposure

In 2005 Hermes, manager of the BT Pension Scheme, the UK’s biggest pension fund, took a brave step out of mainstream equities and invested 3 per cent of the scheme in commodities.

It took the view that in the long term, investing in a commodities tracker fund would pay higher returns than bonds and similar returns to equities taking account of inflation. It is now considering raising the allocation to 5 per cent.

Hermes was an early mover. In 2005, most of
the UK’s pension schemes had little or no exposure to commodities.

Wealthy and sophisticated individuals have long invested in commodities. Some US funds, notably several Ivy-league endowment funds, had big investments in commodities – and a wide variety including timber – partly to hedge their exposure to equity markets and help match their liabilities to asset flows.

Managers point out that US endowments attract money when financial markets rise, but a high proportion of their long-dated costs are energy and food based and tied to inflation.

Yet pension funds have tended to shy away from commodities. The most innovative schemes – largely in the Netherlands and some in the US – first started to put sizeable chunks of their holdings into the asset class about five years ago.

One of the first was ABP, Europe’s largest pension fund, which started shifting its asset base to real assets and private equity in 2001. Since then it has increased its targeted exposure and aims to have about 3 per cent of its €220m ($345m, £173m) in commodities within a year or so.

APG, ABP’s investment subsidiary, says including commodities in the portfolio improves the risk-return profile: “The risk for the total portfolio decreases, while the expected return does not correspondingly decrease. A second advantage of investing in commodities is the compensation that it offers for inflation.”

Some US pension funds have been quicker than UK funds to invest in commodities with Calpers, California’s public employees state retirement scheme and one of the world’s biggest pension funds, investing about 3 per cent in commodities.

Ontario Teachers Pension Plan has put closer to 5 per cent of its $100bn funds in commodity-related investments. Most is invested through enhanced index agreements linked to the S&P Goldman Sachs Commodity Index, which is heavily weighted to oil and gas. But it also has direct investments in timber and coal, and gas companies.

Some analysis suggests that putting up to 15 per cent of total funds into a commodities tracker would continue to reduce risk, while paying out the same kind of excess returns that have characterised equities over the long term. However, very few funds have more than 7 per cent in commodities, says Bob Greer from Pimco in the US.

Chris Burton, a manager at Credit Suisse in New York which has $2.6bn in commodities funds, says: “Since 1970, US equity indices and the S&P GSCI have only fallen in the same year twice.” And in the past nine months, while both fixed income and equity markets suffered the impact of the credit crisis, the GSCI was up 33 per cent in 2007 and 17 per cent in the year to date.

The correlation is not entirely negative, Mr Burton says. Commodity markets do not necessarily rise when equity markets fall or vice versa. But, he adds, investors would not be attracted by an entirely negative correlation since, over time, equities have paid out high excess returns.

The point is that the two asset classes respond to different stimuli. Financial assets are tied to future cash flows, while the main
drivers in commodities are inflation and global growth patterns. There are also
commodity-specific factors, such as weather, that affect supply – from a drought in Brazil to floods in India.

Hermes’ strategy has worked well, particularly recently as oil and gold prices continue to reach new highs, while financial markets have fallen.

Until now Hermes has invested passively, sticking to an index tracker following the Goldman Sachs Light index, which is less heavily weighted to oil and gas and diversified into other stock, such as soft commodities.

But like many investment managers, Hermes is considering a more active approach to commodity investing to minimise investment and trading costs.

In time, says Mr Naylor, the BT scheme’s exposure to commodities might be half active and half passive.

A recent survey of attitudes for the National Association of Pension Funds in the UK shows that most managers think exposure to the asset class will rise sharply over the next few years.

Even so, many investment consultants remain wary. In part, they argue that the structure of the market and commodities futures makes investment expensive, particularly if the cynics are right and the recent spike is little more than a bubble.