Indexation debate
In terms of investing in commodities, futures and derivatives are generally seen as the best method, given the problems of physically owning commodities. However, there is debate over how futures are held, with the trend of indexation being strongly criticised by some, such as Wyke.

Different commodities vary in performance and there is a view that agriculture is now about to outperform in the way oil has done in the last few years.

“Commodities are such an inefficient asset class, indexation has been a disaster. It is a natural for active management,” Wyke comments.
This is because index funds operate by typically buying a one month future and holding it close to maturity, then rolling it over. This causes contango, or future prices rising above spot prices, meaning investors lose money on the rollover (backwardation is the opposite, when future prices are below spot prices).

“What happens when you throw billions of dollars at one part of the futures curve?” Wyke asks. His answer: “Prices go up. Index funds all roll over on the same few days, so there is roll congestion, record profits for commodity traders, and index funds have massively underperformed.”

Ermitage vice-president for hedge fund research, Daniel McAllister, agrees that negative roll yield has been an issue and some investors are unhappy, but added that index funds also produce returns from movements in the spot price and from the return on collateral held to back future.

In addition, Wrobel points out that commodity prices can easily move: “Contango and backwardation is something hat comes and goes. Yesterday there was contango in the oil market; today we have backwardation in oil. It comes and goes depending on the tightness in the market.”

The age-old argument for indexation, Wrobel also states, it is investors know what they are getting, “whereas if you invest in someone’s brain, you are not sure of the outcome.”
Other options for commodity investing include ETFs and fund of funds, with some of the latter using hedge funds to access commodities.
ETFs can either hold commodity indices, with the drawbacks outlined above, or there are ETFs for gold, silver and platinum, which are backed by physical reserves. However, most new investors will want to hold a basket of different commodities.

Ermitage invests on a fund of funds basis and McAllister comments: “If you liken an index to beta [market return] and an enhanced indexation fund to beta plus, we would liken ourselves to alpha generation. We look for hedge funds that trade in commodities or commodity-related equities.”
Forsyth’s Haesen says: “Hedge funds will offer some downside protection if they are structured in the right way.”

Whatever type of fund is used, commodities are also seen as a hedge against inflation. State Street Global Advisors global asset allocation portfolio manager, Dan Peirce, says the central bank response to current credit problems of increasing liquidity is likely to raise inflation, making commodities are useful hedge. However, he warns: “Sometimes trends can get too crowded and you have mini blow-offs, when people get too bullish in the near term.”
In terms of the allocation to commodities, many pension funds and other institutional investors have started by allocations of up to 5%. However, those managing multi-asset funds often have 15-20% in commodities.
In conclusion, demand for commodities is, according to the experts, set to increase and its diversification properties, coupled with the current positive story, make it a very interesting asset class for investors.

We’ve had index funds, hedge funds, and private equity. Now commodities are seen as one of the next big things for investors. It is a very old asset class, but until the recent equity bear market alerted investors to the attractions of a fully diversified portfolio, few investors held it. Now, it is seen as a strong stabilising element in portfolio and one that is currently enjoying attractive returns. Patrick Armstrong, co-head of Insight Investments multi-manager group, comments: “Basically commodities are uncorrelated to traditional assets such as equities and bonds. In times of market stress, it can even have a negative correlation, which is very beneficial.”

Commodity markets are known for long bull and bear market cycles and one view is that the market is now in the early stages of a bull market phase that could last for years. This would be typical of market cycles in commodities. As Schroders commodity and agriculture product manager Christopher Wyke says: “Up until four or five years ago, commodities were in a 20 year bear market. Over the last 100 years, commodity bull markets have lasted 15 to 20 years.”

Commodities is a very old asset class, but until the recent equity bear market alerted investors to the attractions of a fully diversified portfolio, few investors held it.

Fuelling development
There are a number of reasons for the bull market, with the rapid industrialisation of China, India, and other developing nations being one of the most important. Aljoscha Haesen, manager of the Forsyth Global Commodity Fund, comments: “China is driving very strong demand, but it is not just China. As economies develop, their demand for commodities goes up. More infrastructure is needed and mining companies have increased expenditure in meet demand.”
So it is not surprising that investors are now putting more into commodities. According to Stephan Wrobel, chief executive officer of Diapason Commodities Management, the total assets invested in commodities has gone from USD 5 billion at the start of this decade to over UK£100 billion now.

Most of this money is invested against commodity indices, although hedge funds, actively managed funds, and exchange-traded funds (ETFs) are also used by investors.
One of the attractions of commodities as an asset class is that it covers a large basket of different raw materials and foodstuffs from crude oil, base and precious metals and minerals, through to agricultural products, such as corn, cocoa, coffee, and livestock. Different commodities vary in performance and there is a view that agriculture is now about to outperform in the way oil has done in the last few years.

Wyke comments: “A vast number of people have joined the global economy in the last 20 years, as countries have got richer, and they want to eat more food, particularly protein.”

Or as Armstrong puts it: “The emerging middle class in China and India are moving from a grain-based diet to a meat-based diet. This actually means even more grain is now needed to feed chickens and cows.”
Commodity pundits say that although technical factors, momentum, and liquidity can affect prices temporarily, fundamentals really drive the markets.

Fundamentals pushing demand for agricultural commodities include population growth, rising living standards, low inventory levels, urbanisation, and even environmental factors such as desertification and topsoil erosion, which is reducing suitable agricultural land. This is according to Diapason’s research, and Wrobel adds: “In real terms, agriculture prices were at rocket bottom two years ago. Because inventories are very low, there is no cushion for rising demand, so agriculture prices could rise very sharply.”