Another good piece on the merits of allocating to Commodities – and why an actively managed approach to Commodities investments makes sense.
Mark
So commodities are worth their weight in gold
By John Authers
Published: September 23 2006 03:00 | Last updated: September 23 2006 03:00
This decade’s surge in commodity prices - from precious and base metals to energy - has helped to revolutionise the way we can invest in them. Hedge funds discovered them as a new hunting ground just as their traditional livelihoods were threatened by the bear market in stocks and the decline in volatility.
Institutions have found their way into commodities over the past year. The exchanges that trade them have suddenly turned into the hottest stocks out there.
A welter of academic work has come to the conclusion that commodities belong as a core asset class for fund managers, with stocks, bonds, and cash.
And if you, the retail investor, want to try it yourself, that too is possible. The last year has seen a plethora of launches of exchange-traded funds and notes in the US, enabling you to buy and sell futures based on a commodity index, or even the commodity itself, over an exchange. Next week will see the concept come to the UK, in style. ETF Securities will launch 29 securities it calls Exchange-Traded Commodities (ETCs) on the London Stock Exchange. These will track indexes drawn up by Dow Jones and AIG Financial Products, and will allow very narrow bets.
It will be possible to buy ETCs in virtually any commodity from aluminium to zinc. If you want to run your own managed futures hedge fund on your laptop, it looks as though now you can at least try.
The question is: should you want to? And is the concerted attempt to turn copper and wheat and the rest into an investable asset class anything more than a reaction to their bull run of recent years? It is hard not to believe that the investment management industry has been guilty of chasing performance, and launched into commodities because they seem to be the flavour of the month (perhaps literally, in the case of coffee or cocoa).
Cynics get extra ammunition from the timing: all this interest has come just as the long bull market in commodities seems to be breaking. This week brought the first signature commodities “bust”, as the Amaranth hedge fund announced that it had lost two-thirds of its $9bn in capital in barely more than a week, thanks to disastrously misplaced bets on the natural gas market.
Crude oil, which earlier this year was supposed to be heading north of $100 a barrel, slipped below $60 in London, 24 per cent below its high of July, as worries about the Middle East and US hurricanes subsided.
Gold and other precious metals are also way off their highs. The Goldman Sachs Commodities Index, the most commonly followed benchmark of the sector, has fallen 15 per cent over the past 12 months, while the DJ-AIG Commodities index is up only 0.1 per cent. In May, they boasted 12-month returns of 22 and 27 per cent respectively.
So has the bubble burst? Or is there reason to stay interested in commodities? The balance of the academic research, taking the long view, suggest that there is.
Finance professors Gary Gorton of the Wharton School and Geert Rouwenhorst of the Yale School of Management, in what is already a seminal paper, found that in the long run commodities have similar characteristics to stock, with about the same returns and volatility. From 1959 to 2004, buying and holding a basket of commodity futures delivered average annual returns of 11.5 per cent - identical to stocks. The standard deviation - the basic unit of volatility, where all but 5 per cent of the time returns will be within two standard deviations of the average - was lower for commodities at 12.1 per cent, compared with 14.8 per cent for stocks.
Even more appealingly for risk managers, their returns are not correlated to equities, so they should pick up the performance baton when equities are lagging.
A subsequent study by Ibbotson Associates for Pimco found that for any given level of risk, adding commodity futures to a portfolio of stocks, bonds and cash would increase expected returns: golden words for an asset manager.
What about timing? Many commodities obey cycles, gaining when demand outstrips supply, then slipping once supply has been over-expanded. Was the bull market secular, or merely cyclical?
The one word answer from commodity bulls is: China. Its voracious demand has raised prices for many commodities, particularly base metals. If you feel confident that Chinese growth will continue unabated (a big if), the bulls may have longer to run.
However, the research has already spawned academic dissent. Harry Kat, finance professor at the City University’s Cass business school in London, attacks the arguments about China, and adds that energy contracts are much riskier than other commodities.
He concedes that the investment case for commodities as a diversifier is “remarkably robust”, but that their expected return is critical to a decision on whether to buy them now.
“As long as the global economy does not suddenly dip,” he says, supply will take time to catch up with the demand from manufacturers. Thus the most uncertain factor is the demand from investors themselves.
“If the current commodity investment boom persists,” he concludes, “it is not unlikely that prices will remain high or rise even further, thereby leaving the case for commodities intact.”
The proof of the world economy will unwind over the next few months. And given this week’s shocks, the proof of investors’ demand will become clear very soon. Longer term, all investors should pay more attention to commodities than they once did.
This is a significant outperformance over the GSCI -7.26% (August) -0.43% (YTD) and DJAIG -4.02% (August) -0.16% (YTD).