LONDON Pension funds that invest in commodities to diversify portfolios need a different approach that involves understanding fundamentals and targeting certain areas, because the sector as a whole no longer fulfils the role.
Natural resources have historically had a negative correlation with equities. Commodities reflected immediate economic conditions, while the stock market tends to discount expectations for future growth and earnings.
But that relationship has broken down.
"Investors looking to use commodities for diversification would be better off looking at specific parts of the sector," said Philippe Bonnefoy, founder of fund firm Cedar Partners.
"They should have the resources to make an energy call or a metals call. Within metals is it base or precious? We can then begin to rifle-shot rather than shotgun asset allocation."
Investors are turning to new financial products that allocate among commodities based on fundamentals, following many years of making passive long-only bets on the sector as a whole using tools such as the Standard & Poor's GSCI .SPGSCITR commodity index.
Barclays Capital, for example, offers clients indexes that allocate using the fundamental views of its analysts.
Another alternative for pensions is to allocate to external fund managers who use their skills and expertise to buy and sell on the basis of supply and demand, consultants Mercer said.
"Active management became more prominent with our clients last year," said Simon Fox, a principal at Mercer. "One of the reasons it didn't become more prominent sooner was the 2008 financial crisis."
The ideal solution would be to make commodity allocations the way investors make equity allocations -- an overall allocation to equities and then within that to retail, banks, utilities, miners, oil producers and other sectors.
"Investors can make a general allocation and then within that make separate allocations to the different sectors," said Kimberly Tara, chief executive at FourWinds Capital Management.
"I don't think there is much debate about the fact that the fundamentals of energy and agriculture are quite different, which are both very different from sugar or coffee. Commodity allocation now needs a different approach."
The 20-week moving correlation between Britain's benchmark FTSE 100 .FTSE equity index and the S&P GSCI jumped to above 90 percent in September 2010 from zero and below before the crisis of September 2008. It is currently above 50 percent.
Recent high positive correlations have been reinforced by a much bigger weighting -- nearly 13.9 percent now compared with 6.9 percent five years ago -- of miners in equity indices such as the FTSE 100.
The index also houses HSBC (HSBA.L) and Standard Chartered (STAN.L), banks with much of their business in emerging economies that have a high exposure to commodities.
"The recent sell-off provided a useful reminder of the inherent volatility of commodities and its close relationship with other risk assets," said Frances Hudson, global thematic strategic at Standard Life Investments.
"Some commodities like cocoa or coffee have their own issues in terms of weather systems. Grains are seeing greater demand and are also driven by weather."
GO ON FOREVER
One reason the positive correlation is so high is the current lack of returns on cash. This effectively removes any perceived disadvantage in investing in commodity futures, which offer no income or dividends.
Interest rates in the United States, Britain and Japan are effectively zero, and in the euro zone are low by historical standards.
The U.S. Federal Reserve has pumped large amounts of liquidity into the global financial system in an attempt to sustain economic growth.
"This very generous monetary policy of the Fed is fuelling flows into both equities and commodities," said Alexander Ineichen, founder of Ineichen Research & Management.
"In theory accommodative policy could go on for ever, but nothing lasts forever and at that point I would also expect the positive correlation to break down. There is also the argument that the correlation is mean-reverting."
Eliane Tanner, commodity strategist at Bank Sarasin, says commodities still provide diversification benefits.
"Over the longer term the correlation between commodities and equities is low," she said. "The high correlation at the moment is overstated ... and should decline again. While both asset classes are cyclical, they still have their own drivers."
(Graphics by Scott Barber; editing by Jane Baird)