Commodity investing: papering over the problems

As funds globally review their investment policies, investment consultants are now strongly endorsing commodity investment, with funds generally planning a staged 3 to 6 per cent strategic allocation into commodities. Writing exclusively for conexust1f.flywheelstaging.com, chairman of Mountain Pacific Group, Ronald Liesching, traces the history of commodity investing, highlighting the risks and benefits for pension fund investors.

Commodity investment has gone mainstream. Funds are reducing their risk by hedging their paper financial investments with exposure to real commodity assets.

Commodity investment is controversial, as was equity investing in the 1950s, private equity in the 1980s and hedge funds in the 1990s. But the investment logic is irrefutable: commodity investments are liquid, scalable and reduce total fund risk while enhancing returns [“Commodities now”, R Liesching, 2009]. So once you include commodities as an asset class, the allocation is inevitable.

But the real reason for investing in commodities is deeper thinking by fund staff about the changing structure of world power. Travel globally and you see the shift of power from the developed, post industrial world, to developing countries. The world’s population is now 6.78 billion. The year 2008 was a very special year for mankind: it was the first year in the world’s history that 50 per cent of the world’s population lived in cities.

People in cities need high energy food, they need accommodation, they need to travel. The world population will expand by another billion over the next 13 years [“Surfing the big wave”, R Liesching, 2008]. Every week you see the Chinese government securing their future massive commodity needs. Last century saw all easy commodity supplies exploited. Now, linear trend growth in commodity supply is meeting nonlinear growth in demand.

Easy paper supply

Japan, Europe and the US are aging societies. The demographic time bomb is now going off. In the United States most public pension funds are near 25 per cent underfunded, and many European countries have unfunded, pay-as-you-go pensions.

The pension arithmetic does not work. The Western financial crisis was due to financial paper claims on future real goods expanding far beyond future creation of real goods. With an aging population, it is political suicide to cut pension benefits by 25 per cent.

The gentler way is inflation: pension claims will be debased by inflation. With weak personal savings, the developed economy central banks have been forced to paper over the financial crisis by monetizing worthless paper financial claims. The Fed’s balance sheet has more than doubled. The supply of high powered paper money is doubled, with weak aggregate global real demand.

Inflation fell for the last 25 years. So paper financial assets dramatically outperformed real assets. The best inflation hedge is TIPS. The IMF estimates that the entire global TIPS market can only meet 3 per cent of the inflation hedges needed by global pension funds and insurance companies. Commodities are second only to TIPS as an inflation hedge.

Investing in commodities

Funds initially invested in commodity indices. But “indexation is a misnomer: Turnover in these strategies can be 1200 per cent per year, and the commodity weighting is arbitrary. Like fundamental equity “indices”, commodity indices are different rule based investment strategies. It is a risky ride if that index rises, and then falls, by 50 per cent.

So funds are now employing second generation active commodity investing, as they consider more deeply the role of commodities in their portfolio. The country where your fund is located is a major issue in sizing and configuring commodity mandates.

Japan has no commodities and exports traded goods. Thus when commodity prices rise, Japanese equities generally fall. Active commodity investing significantly offsets equity downside risk.

In contrast, countries like Australia and Canada, have long commodity exposure via equities, so the commodity investment has to be adjusted.

In the US, equities also bring pre-existing commodity exposures. The new wave of institutional commodity investing is explicitly active, and tailored to achieve portfolio level goals.

Structural changes in commodity markets

For most of last century, commodities were in plentiful supply and often fell below marginal production cost. Commodity producer profitability was at risk, so producers sold commodities forward at price discounts to hedge their revenues. These discounts were so persistent, that it was called “Natural backwardation”. It was very unnatural to sell real commodities forward at a discount, when overall goods inflation was positive. This anomaly created another paradox: the “Equity return premium puzzle” [Mehra & Prescott 1985,”The Equity Premium: A Puzzle”, Journal of monetary economics, 15, pp 145-161.] Equity returns were abnormally high as manufacturers bought raw materials at a discount. That puzzle is now gone. Commodity prices sell at a forward premium. Commodities should be in “Natural contango”.

Tie down your camel!

Commodity investing remains controversial. There are questions to answer: Is it an asset class? What is the expected return premium? Isn’t commodity investment just speculation? And there are massive structural changes occurring which have torn up historic fundamental relationships in the commodity market. We are at the very beginning of the financialization of commodities.

Commodity prices are an exchange rate between real physical goods, with finite supply and increasing demand, and paper money, where supply is only limited by political will.

We may hope that the world’s rural population will not migrate to cities, we may hope that politicians may balance budgets and that our central bankers will stop monetizing debts.

But there is an Arabic saying “Before you go to pray, tie down your camel”.

Fund staff are investing in commodities because they are fiduciaries. They want to build their fund’s assets and protect the beneficiaries against risk of real loss. Commodity investment is the best hedge for the future real value of pensioners’ retirement assets.