INVESTING IN COMMODITIES
benefits of diversification could be lost. Simon Hayley of Capital
• Consumption of natural resources will expand during the
Economics has issued a paper to explain recent events. His evidence
next two decades, driven by continued industrialisation and
shows that, to assume that the correlations between commodities
growth of domestic demand in emerging markets.
• Resource supplies will continue to face difficulty keeping
and equities is low would be “complacent”. (See Box II).
pace with demand, encouraging substitution and
exploration activity.
Commodity Investments
• Projections of near-term supply shortfalls in natural resource
Global investments in commodities are estimated between US$130-
markets, combined with the potential for future substitution
150 billion. This compares with up to US$50 trillion in equities (of
effects, suggests that active portfolio management
which about US$4 trillion is invested in energy, metals and mining
strategies are becoming increasingly relevant for
companies), and US$ 20-25 trillion in debt markets.
investments in commodities.
In relative terms, therefore, these markets are small – although
they exert significant influence on all others.
ones. First, it has included practically all Investors, meanwhile, are getting smarter, the most important
commodities. Secondly, it has not been trend being investor scepticism about traditional commodity index-
accompanied by a significant exoge- es. Many are switching to more actively run hedge fund and other
nous geopolitical shock. But the real alternatives. And as the population of investible commodity indices
driver of the last three years has been has exploded, their performance has become highly divergent. As a
the emergence of China and India as result, investors need to be acutely aware of the characteristics that
both consumers and producers, and the differentiate the numerous commodity index products in the mar-
large inflows of capital into the complex ketplace (see page 40).
as investors have looked to re-allocate UBS has gone as far as developing a new portfolio-based algorith-
their portfolios. mic strategy which exploits momentum in the commodity markets to
Taken together with the emergence of generate returns through automated long and short strategies (see
new investment firms and more com- page 14). More banks are either expanding their presence or joining
modity investment vehicles, the picture the commodities party as new participants. Many have flip-flopped
becomes clearer as to why the complex this sector over the years but now seem convinced that the power,
continues to prosper. influence, prestige – yes, and money – to be made by participating in
While commodity strategies on their this sector is critical to their overall business success. “The movement,
own are generally considered highly the importance of commodities, is going to continue to expand and
volatile, their negative correlation to develop ... we are in a cycle that’s going to continue to be bullish for
equity and inflation-hedge characteris- commodities in general,” Marc Mourre, Head of Commodities
tics can help offset potential losses in Marketing with Morgan Stanley recently told Bloomberg.
other assets classes. That much is now Equally, Asian and Middle Eastern companies, together with the
perceived wisdom. Or is it? sovereign investment vehicles, are becoming ever more influential in
When an asset class goes ‘main- this sector as they seek greater access to assets.
stream’ as is the case here, the likely The financial demand for commodities – what John Normand of
JPMorgan describes as the ‘X Factor’ – is a relatively new phenome-
Investors Over-Estimate Diversification Benefits
non but assumed to be rising relative to physical demand. Though,
The correlations between commodities and equities/bonds has
as many note, these flows and positions are difficult to quantify as
risen substantially. Admittedly, gold and emerging market bonds
no public, comprehensive, high-frequency data source is available.
have shown negligible correlation with developed market
Canny investors are already taking a more active role in allocating
equities over a five year period. But over the last six months,
money to this sector, such as investing in natural resources-linked
these assets have been showing significant positive correlations.
equities funds and ETCs. In the pages that follow we have asked a
Some commentators continue to stress that long-term
number of key specialists from the commodity markets to give us
historical correlations between the two sectors remains modest.
their views on the structure and potential for commodity markets
However, correlations between different risky asset classes have
going forward. In so doing, we should remember that commodity
long tended to rise during periods of increased risk aversion. As a
resources on the whole are finite and their depletion needs to be
result, diversification benefits diminish precisely when investors
managed in a sustainable manner. And as the world’s population
need them most.
grows and urbanisation increases, demand for these ‘things’ will
Large funds across the world are also tending to invest in the
grow proportionately.
same asset classes, so there is more reason to suspect that shifts
But a critical question remains: How long can the current boom in
in risk appetite will affect all these asset classes as investors
commodity prices continue? That depends very much on the com-
adjust their overall exposures.
modity in question. Certainly, the long-term arguments for some –
“For all these reasons we believe that investors may still be over-
estimating likely diversification benefits. This un-preparedness
particularly energy and agriculture – remain firm. And newer com-
could, in turn, worsen any future sell-offs as investors belatedly
modity markets, such as those for renewables and emissions, and
re-asses the degree of risk in their portfolios and reduce exposure
the vehicles giving exposure to them, will also develop further and
across a range of asset classes.”
should not be overlooked •
Capital Economics, August 2007
www.capitaleconomics.com
Guy Isherwood is Editor of Commodities Now magazine.
32 SEPTEMBER 2007 COMMODITIES NOW
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