How to invest in commodities

With commodities experiencing a bull run, they are an essential part of any portfolio.

Talking to the typical retail investor about their target allocation to commodities, you find that more often than not, the target allocation is zero. Private clients, who have access to more sophisticated advice, generally have slightly higher allocations of approximately 1%-3%, but still almost certainly lower than the 10%-20% allocation some experts recommend.

Connoisseurs of commodities compare their inclusion in an investment portfolio to the making of a fine martini. With commodities, like vermouth, a little goes a long way and makes the whole thing a lot smoother.

The smoothing effect of the asset class comes from the fact that commodities exhibit low or negative correlation with traditional fixed income and equity portfolios.

This characteristic was identified in a study conducted by Yale's International Centre for Finance in June 2004. It concluded that commodities "have been especially effective in providing diversification of both stock and bond portfolios" whilst providing stock-like returns for less risk.

Since Harry Markowitz put forward the Modern Portfolio Theory in 1952, accepted wisdom recognises that an appropriately diversified portfolio can achieve optimal risk-return characteristics. So adding a non-correlated asset to a portfolio can boost performance whilst technically reducing risk in the overall portfolio. Hedge funds have benefited from general acceptance of this theory over the last five to 10 years, but commodities - another non-correlated asset class - have largely escaped notice.

Commodities can significantly reduce volatility (thereby improving the Sharpe ratio) of a portfolio when incorporated at an optimal allocation. Broad-based commodities exposure in a diversified portfolio acts as a natural hedge in times when traditional asset classes underperform.

Jim Rogers, founder of the Rogers International Commodity Index (RICIX) and The Diapason Rogers Commodity Index Fund, suggests that investors ignore the asset class at their peril. "Commodities are so pervasive that, in my view, you really cannot be a successful investor in stocks, bonds, or currencies without understanding them," writes Rogers in the opening line of his recently published book: Hot Commodities.

Jelle Beenen, head of commodities at the €57 billion PGGM Pension Fund, advises that by reducing bonds, equities and property holdings by 20% and allocating that 20% to commodities, PGGM sponsors can reduce their pension contribution by 15% without increasing the overall risk of the pension fund.

Given the strong case for commodities adding value in an investment portfolio, why have so many investors given them the cold shoulder?

A low allocation may simply seem like good sense when you consider that the commodities market has risen twofold since 1999. Sceptics eye the bull run suspiciously and ask why buy now if you haven't invested so far?

Rogers, who is often described as the Warren Buffett of the commodities world, couches a response in the context of the equity bull market which started in 1982-3 and which saw the S&P 500 Index triple over the following seven years.

"If I had told you to put all your money into stocks [in 1990], you would have hooted me out of the room: Surely, no rational being would believe that stocks could continue to rise after tripling in a few years," writes Rogers. In fact the S&P 500 quintupled over the following decade.

In 1999, commodity prices (inflation-adjusted) reached their lowest point in over 100 years while the NASDAQ soared on the back of dotcom and tech stocks. At that time no one would have been persuaded to switch from the booming tech sector to commodities. Certainly nobody was listening to a small group of commodity specialists shouting from the rooftops that a bull run in commodities had just begun.

Now, five years into that bull run, investors should think twice before hooting commodity bulls such as Rogers out of the room. If Rogers is right, we are at the start of a 15 to 20 year bull run in commodities.

Historically, commodity cycles have had an 18-20 year lifespan. Intuitively, commodity cycles are protracted due to the physical nature of the asset class and the lengthy processes of exploration and mining. The bear market that lasted till 1999 meant that many commodities companies underinvested in exploration and now, despite a supply response generated by the pick up in demand in recent years, market inventories have been run down to extremely low levels.

Sceptics of the "super-cycle theory" point to a faltering global economic recovery and a slowdown in Chinese growth narrowing this gap between commodity supply and demand.

Jim Lennon, leading resources analyst and global head of resources research at Macquarie Securities, disagrees. "Demand growth from China and other countries such as India will continue to drive above trend global demand growth for many years to come. Supply constraints will prevent a sufficiently rapid production response so any move into oversupply will be delayed. Markets will stay tight for a prolonged period with prices remaining 'stronger for longer' or even pushing to new highs," he says.

Chinese growth will continue to be the biggest driver of the commodities market, says Lennon. China has gone from 7% to 10% of world demand for the main base metals in 1993 to 20% to 25% in 2003. Even allowing for a slowdown from current growth rates, China is likely to account for 30% of world demand by 2010. "Chinese demand has exploded and it is relatively poor in reserves of many raw materials," says Lennon.

Assuming China's industrial development stays on track with GDP growth averaging about 7.5% over the next 15 to 20 years, and even if OECD demand growth for commodities slows from the average 3% a year levels of the past two cycles to about 2% per year, overall global demand growth would still average 4% to 5% because of the impact of China.

"This would be the strongest demand growth since the 1950s and 1960s and this is set to keep markets tight and inventories low," says Lennon.

Mining the market

Learning to love commodities as an investment idea may be the easy part. Figuring out how to gain exposure to this asset class is more tricky.

Historically, access to commodities was through the futures markets via industry participants hedging real business risks and commodities trading advisors. This is perhaps why so many private clients are heavily underweight the asset class. The futures markets can be perilous for the inexperienced investor and stories of people losing their shirts trading pork bellies can have prospective investors running scared.

Today, however, accessibility has improved dramatically, and investors can achieve exposure to this asset class either directly or through a number of products.

The purest form of access is through futures contracts. Execution can be difficult because investors have to continuously monitor the markets, supply and demand dynamics and margin to equity - which is beyond the scope of most busy private clients. Given this, most investors prefer to outsource the management of their allocation to professionals.

Structured products are an increasingly attractive form of access to commodities because the buyer can tailor the structure to their risk and reward parameters. There are also a growing number of structured products available ranging from capital guaranteed to delta one (where you are buying the underlying investment one-for-one) to leveraged products.

Structured products also allow investors to tailor the mix of the underlying asset to their experience and risk tolerance. The investor can buy a basket of physical commodities for a surgical approach to playing out a particular view on a section or sector of the markets, or buy an index-based structured product to achieve the broadest diversification.

The arguments that commodities demand will remain strong and supply in certain metals and agricultural commodities tight for some time to come means the investment outlook should remain positive. The growing range of products available to the private investor provides greater access to this rich seam of opportunities.

How to get exposure

Direct futures exposure: Futures contracts can be purchased through a broker with a commodities trading licence. This is the purest form of commodities investing, but potentially the riskiest to the inexperienced investor. Generally, it can also be time-consuming requiring daily market monitoring and margin analysis.

Commodity-focused equities: Probably the easiest and most comprehensible approach for private clients. The asset is well researched, easily understood and accessible.

Certificates: Direct participation products issued by investment banks to provide private clients with fully collateralized exposure to the movement of the futures markets.

Long Funds: Funds largely comprising commodity focused or involved equities. They achieve diversification but are generally limited in choice.

Structured Products: Achieve a number of different payouts and are potentially the most flexible due to the 'tailor-made' nature of the structuring process.

Indices: A commodities-related index, eg. Reuters-CRB Index or the Rogers International Commodity Index, comprises a basket of commodity contracts. Generally used as a proxy for commodity performance rather than an investable product. Structured products have effectively bridged the gap between index and product.

Commodity Trading Advisors (CTA): Absolute return trading strategies, which take both long and short positions on commodities. Normally blended with other asset class futures (equities, interest rates, currency) so despite the name, commodities may only make up a small percentage of these products. Long/short positions mean the products potentially lag in a bull market but outperform in a bear market.