By John Kemp
LONDON May 30 Unless returns on commodity
futures and options start to pick up soon, institutional
investors may sour on the asset class and scale back or
terminate their exposure to it, ending a decade-long trend that
has seen increasing financial involvement in commodity
The first five months of 2012 have brought more
disappointment for pension funds and other investors with a long
position in a diversified basket of commodity futures.
It has been a rough ride for investors across most asset
classes, except ultra-safe havens like U.S. Treasuries and
German bunds, as early optimism has given way to growing fears
about the outlook, repeating the cycle of hope and despair
evident in 2010 and 2011.
But the performance of commodity futures has again lagged
behind equities. While the S&P 500 U.S. equity index is
still showing gains of almost 7 percent for the year, after
peaking up 13 percent in early April, the S&P Goldman Sachs
Commodity Index and its various derivatives are down
5 percent, after peaking up about 10 percent in late February.
Both indices are quoted on a total return basis.
My colleague Javier Blas at the "Financial Times" has
written an excellent article asking whether the so-called
"super-cycle" has run its course ("A less-super commodities
supercycle" May 29).
"The boom in demand that has propelled prices of raw
materials from oil and copper to iron ore and bananas to record
highs is showing signs of exhaustion," Blas writes.
"It makes more sense to think of the commodities super-cycle
not so much as a looming bust but as less "super" and less
"cyclical". Raw materials prices are likely to settle at a
higher level than previously, with ups and downs tracking swings
in economic activity."
"Long-only passive investors tracking popular commodities
indices such as the S&P GSCI, who have simply ridden
year-after-year price gains without worrying about the
difference between, say, aluminium and cocoa, would be unlikely
to make as much money," in a new era of trendless high prices,
RISK PREMIUMS EVAPORATE
But even before the super-cycle ran out of momentum, passive
investors in commodity futures and options were struggling to
make money. Returns on the GSCI and its derivatives have been
lower than U.S. equities over almost any time horizon since 2000
Unlike an investment in equities, commodity futures do not
provide a stream of dividends. Instead investors have been hit
with the cost of storage. Passive index investors have been hit
by the reduction in bond rates, which has hit the collateral
yield on the safe financial instruments used to collateralise
their holdings of commodity futures.
There is also evidence that some commodity markets have
become overcrowded, with index investors competing away the risk
premium and roll yields that existed before the asset class
became fashionable in 2004.
For a time, the surging spot prices for a range of
commodities, from crude and copper to iron and cotton, masked
the deterioration in underlying performance of the indices. But
as the super-cycle gives way to a period of plateauing prices,
the problems with a passive long-only exposure are becoming more
PENSION FUND RESPONSES
Pension funds and other institutional investors, along with
their professional advisers, are notoriously slow to respond to
new investment trends, given the thoroughness with which they
must assess the appropriateness and risk of asset allocations.
It is this "stickiness" which makes them attractive for the
sell-side of investment banks.
Pension funds were relatively slow to respond to the
promotion of commodity derivatives as a new asset class. But
between 2004 and 2010, the institutional sector poured hundreds
of billions of dollars into indices and actively managed funds
benchmarked against them.
Pension funds were encouraged by a strong sales effort and
academic research such as "Facts and Fantasies about Commodity
Futures," published by Gary Gorton and Geert Rouwenhorst in
2004, which appeared to show that a diversified long-only
investment in commodity futures could produce similar returns to
equities with similar risk, as well as protecting against
inflation, and adding useful diversification to a portfolio.
Unfortunately, commodity futures have failed to match the
return on equities, and proved increasingly poor diversifiers.
Only the argument for inflation protection remains.
STICKY BUT NOT STATIC
While pension fund strategies tend to be sticky, they are
not static. The years of under-performance are prompting a
rethink, as well as a new set of sales pitches.
The most limited strategic response is to pick a more
"dynamic" index which seeks to optimise the maturity and rolling
of futures contracts.
A more radical strategy permits a more dynamic re-allocation
of exposure between commodity markets either within the
framework of an index wrapper or in a pure hedge fund type
The most radical strategy is to allocate funds to a hedge
fund with a wide mandate to take long and short positions.
Only the most radical, hedge fund long/short strategy is
likely to work on a sustained basis. The others have already
begun to compete away the returns to curve optimisation etc as
the strategies become more widely adopted.
The problem with hedge fund strategies is that returns are
to the skill of the hedge fund manager rather than intrinsic to
the commodities themselves. "Commodities" ceases to be a
separate asset class of its own and becomes simply a sub-set of
Institutions have found it notoriously hard to capture hedge
fund returns, where most of the return has been captured by
hedge fund managers themselves.
New pension-fund allocations to commodities as an asset
class have slowed significantly over the last 18 months. Money
that has already been allocated has increasingly been
transferred from passive indices into more active indices,
active managers, and even hedge funds.
The crucial question is whether fresh allocations will stop,
and money already allocated eventually be withdrawn, if returns
continue to disappoint.
Even if money already committed to indices is not pulled out
of the asset class, it seems very likely fresh allocations will
stop. Pension funds and their advisers, reviewing the
performance of previous commodity investments over a three-year,
five-year or 10-year horizon are unlikely to see a compelling
case to invest, after the recent underperformance.
THE END OF FINANCIALISATION?
The end of fresh institutional investment inflows would
profoundly affect commodity markets. The massive expansion of
investors' involvement has supported an enormous increase in the
number of commodity brokers and market-makers and a big build
out of the major investment bank's commodity dealing divisions,
as well as a substantial rise in staffing levels and associated
It has also driven a substantial "financialisation" of
commodity markets and prices, increasingly correlations among
different commodity prices as well as with other asset classes,
promoting a more forward-looking expectations-driven approach to
Negatively, investors and financialisation have been blamed
for unleashing a series of bubble-like price spikes and crashes.
More benignly, they may have added to market liquidity and
depth, supporting increased hedging over longer periods by both
commodity producers and consumers, and enabling the markets to
handle physical disruptions with less volatility than before.
If pension fund inflows stop, or go into reverse, all these
aspects of financialisation could go the same way.
Predictions about the next phase in the evolution of
commodity markets must be very tentative. But it seems likely
the next few years will see a consolidation of market-making and
brokerage services as the market matures. There are already
signs of this happening, with the closure or downsizing of some
of the second-tier commodity divisions at investment banks.
In terms of price behaviour, the tight correlations among
commodities and with other asset classes seem set to loosen
(some already have) as remaining investors stress differences
(on both demand and supply sides) rather than broad
cross-commodity trends. Less positively, the trend towards
increasingly liquidity may halt, or even reverse.
No one knows for certain. But there are signs the
super-cycle theme and commitment of increasing long-term capital
to derivative markets that dominated the past decade may be
drawing to a close. As usual, the winners will be those who
adapt fastest to the new era.