David Donora joined Threadneedle Investments in 2008 as a fund manager specialising in commodities, after more than 25 years in commodity and derivative-based roles at several financial institutions in London and New York.
He launched the Threadneedle Enhanced Commodities Fund, which he now manages, a year ago. The fund has raised over $340 million and has gained over 39% (in US-dollar terms) net of fees since inception. It is benchmarked against the DJUBS Total Return -- an index of commodities futures -- and has outperformed the index by 8%. The fund's investors are largely sophisticated institutions, many of whom are moving from passive to active commodity investment.
Why did you choose to focus on commodities investment?
Commodity investment is a relatively new asset class, having been around for about 10 years, but is growing rapidly. Interest is moving from passive to active investment. At Threadneedle we identified the opportunity to create products based around experienced commodity trading expertise in order to generate consistent outperformance in this asset class. We are generally looking to capture large fundamental and macro trends within the market.
What is distinctive about investing in commodities markets, compared with running a conventional bond or equity fund?
Commodities are resources with limited supply, and in a high stress macro environment, as we have experienced this year, commodity equities do not necessarily track commodity prices. We have seen the price of gold soar on sovereign debt concerns, yet the price of shares in gold miners have fallen. Similarly, if there is another supply disruption in crude oil such that global demand exceeds maximum possible production and the price soars to over $200 per barrel, I would expect to see shares in oil companies do poorly as well. So, we are focused on the same drivers that equity fund managers use, but understand that the effects will be different.
In addition, with the exception of precious metals, most commodity investment flows through the futures markets. As these markets trade differently from equities and bonds, particularly with respect to prices along the term structure, there are many opportunities for active management to generate value.
What drives commodities markets?
The key overarching macro driver for all commodity markets is the relentless increasing demand on this planet's resources by an increasing population. Global population will reach 7 billion people this year and increases by the size of Germany every year. Much of the population growth is occurring in emerging countries with developing economies and that growth is resource intensive as they add infrastructure to raise their standard of living.
How important is China in your investment strategies?
China and the US are the most important economies in our analysis: China because of its incredible economic growth and resource appetite, and the US because it is still the world's largest economy by some margin. Additionally, the interaction between the two with respect to exchange rates and their borrowing/lending relationship means that energy, agriculture and metals are constantly in play.
So, what is your investment process?
We have a bottom-up process, which means we analyse each commodity market separately first and then within the context of the other markets within each sector.
Fundamentals, such as supply, demand and inventory levels are of paramount importance to understanding where a market stands at present. But the real work begins with analysing data and evidence in order to project into the future. We examine these fundamentals with a view to anticipating meaningful changes in a market's balance. In addition to fundamentals, we also focus on each market's seasonal characteristics, technical as well as structure and liquidity. It is the combination of these factors that provides a framework for establishing our strong conviction views. But, we also incorporate top-down analysis. Understanding the macroeconomic context across both developed and emerging markets as it pertains to commodities is an important component of our process.
But does technical analysis have little part to play when many commodities traders use it as their main tool?
Technical analysis is an important part of our analysis precisely because it is widely used as a decision-making tool. But when fundamental drivers are powerful, such as during the 2010 drought across Europe and Russia, technicals take a back seat until the market establishes some sense of balance.
In which sectors and individual commodities are you overweight and in which ones are you underweight?
Our most significant position is overweight gasoline and distillates as these markets remain tight following the supply disruption of light sweet crude in some Middle East countries. And we are underweight US natural gas as it continues to be produced cheaply and in abundance, and production can respond quickly to increased prices, yet there are no means of exporting it.
What are the greatest risks and opportunities in the current market environment?
The greatest opportunity for investing in commodities is to participate in the growth of emerging market economies without the risk of their specific equity markets or currencies.
While these and Western equity markets will be affected by a wide range of factors, the underlying commodities are a pure play on demand for limited resources. Also, the relentless quest by governments to devalue their currencies in order to gain a short-term export boost means simply that commodity prices will continue to increase during the medium to long term. I see the greatest risk as another financial event, such as the Lehman Brothers collapse in 2008, as something that could temporarily divert commodity prices from their inevitable path.
What is your long-term outlook?
We are constructive on commodity prices during the long-term, but recognise that there will be a lot of ups and downs along the way in each of the individual markets. For us as active managers, this volatility is the key driver of generating outperformance. The fund invests in commodity derivatives rather than physical commodities. So, changes in the prices of the underlying commodities will not be mirrored exactly in the fund price.
During your career, what have been the most significant changes in the structure of the commodities sector?
The evolution of commodities as an asset class has been the most significant development. This has brought a quantum of liquidity to the market as well as another dimension of trading opportunities.
I expect that investments in the asset class, having grown to more than $400 billion today from $10 billion 11 years ago, will continue to grow. And within five years this will be a trillion dollar asset class with an even wider range of investable markets, including coal and iron ore.
This story first appeared in the September 2011 issue of FinanceAsia magazine.
