From the June 2011 issue of Investment Advisor • Subscribe!

June 1, 2011

Stockpiling Commodities

The traditional stock/bond breakdown is no longer enough; for true diversification, clients need to add commodities to their portfolios

Stockpiling Commodities, Investment Advisor, June 2011 Stockpiling Commodities, Investment Advisor, June 2011

Once upon a not-too-long-ago time, most investors believed that a simple dichotomy between stocks and bonds in a portfolio would provide the diversification necessary to withstand the effects of a market downturn. That approach, though, proved to be a fallacy in recent market history. Regardless of the stock/bond breakdown that an investor might have had, and regardless of the mix between corporate and sovereign bonds, between small-cap, mid-cap and large-cap stocks, and between international and domestic assets, the fury of the 2008–2009 debacle proved a force too great to surmount.

That excruciatingly painful experience drove home the tough message that the financial markets are actually a lot flatter than most people had imagined and that diversification would have to take on a new meaning. In today’s global markets, almost all asset classes seem to be linked to each other in some way. That makes it harder for investors, as they regain their confidence and look to put money to work again, to figure out where the diversifiers are, and to get a sense of what investment possibilities not only protect in a downturn, but also offer potential upside.

That’s where commodities come in. This is the one area that a growing number of market participants believe not only fits the diversification and opportunity bills, but is also truly distinct from the markets-at-large. Commodities have a very low correlation to almost all other asset classes, experts say, and it was really the only asset class to have held up in 2008 and after. To boot, the commodities universe is the one area where investors can be assured of being able to capture some of the greatest growth momentum in the global markets, both today and in the longer term, and this is why more and more people are looking to get into it.

The commodities world is vast and spans the gamut from oil and natural gas, to base and precious metals, and on to soybeans, corn, livestock and beyond. Not too long ago, the asset class was viewed as somewhat exotic, says Andy O’Rourke, chief marketing officer at Direxion Funds—an investment universe that elicited curiosity more than anything else, from adventurous investors with cash to spare. The asset class, he says, was a marginal play that investors looking for alternatives dabbled in. Since the 2008 crash, though, the focus has shifted, “and people are now looking at commodities as a specific asset class that they really need because it has a low correlation to everything else in their portfolio, as opposed to before, when the question was ‘can commodities perform for me?’” O’Rourke says.

Andrew Rogers, President, Gemini Fund ServicesToday, the word on the street is that a truly diversified investment portfolio must have some allocation to commodities, and as such, the asset class is becoming more and more mainstream, says Andrew Rogers, (left), president of Gemini Fund Services. As the interest level in commodities has grown, so too have the number of ways in which investors can get into them, he says, and there has been a proliferation of all kinds of investment strategies, ranging from broadly diversified commodity mutual funds to more granular and single commodity-specific ETFs, which are made up of either equities or futures contracts, and provide concentrated exposure to one particular part of the commodities universe.

Rogers—who has overseen the launch of several commodity funds at Gemini—believes this dynamic is set to continue.

“We are about to launch six new funds that have some kind of commodity-based strategy,” he says. “Most of the cash is coming into commodity funds these days, so we see great growth potential in this area and we feel we are on the verge of a whole new era.”

To make a case for commodities as a great investment option for the long term is a no-brainer, because commodities and emerging markets—the engine of global growth—are closely intertwined, says Nathan Rowader, who manages Forward Management’s Forward Commodity Long/Short Strategy Mutual Fund, a broad-based commodity fund with exposure to a universe of 24 different commodities. Emerging market nations are the producers of commodities and the high global demand for these products continues to fuel the development of these countries, he says, thereby making for a compelling long-term investment story.

“The long-term outlook for commodities is extremely favorable, not just because of the high demand for commodities from emerging market nations, but also because of the growing middle classes in those countries themselves,” Rowader says. “A huge portion of the entire world’s population lives in emerging markets, so as the middle classes evolve, the demand for food, for cars, for air conditioners and everything else that require commodities is also driving demand and creating momentum.”

The long-term commodities play has a long, long run ahead of it, Rowader says, taking into account facts like “the average American consumes about 22 barrels of oil per year, and the average Chinese person consumes only about two barrels a year.” But for many investors, it’s the short-term commodities story that looks more compelling right now, especially because commodities make for a great hedge against inflation, and most pundits have heralded a period of impending inflation for the world economy. One of the best ways to guard against this and to protect against the erosion of hard currencies like the dollar and the euro is to buy commodities, Rowader says.

At a time when inflation is rising, allocating some money to “real assets” is a sound decision, agrees Will Riley, co-manager of Guinness Atkinson’s Global Energy Fund in London, and this is what’s driving a lot of the money that’s now coming into commodities.

“As an inflation hedge, gold has had a very good run over the past 18 months, and so have metals and mining,” he says. “Energy has become a safe haven over the past six months, and energy equities look a lot cheaper on a relative basis compared to other equities.”

Beyond inflation, the changes in global geopolitics as a result of what’s happened in the Middle East, coupled with the aftereffects of the Japanese tsunami and earthquake, also have major implications for commodities—especially oil and natural gas—and investors who play their cards right can stand to gain from the changes in the prices of both in the short term. It is this particular dynamic that has bolstered the more tactical, market-oriented approach to investing in commodities that is currently attracting many investors.

Ted Wright, director of portfolio management at Genworth Financial, is one market participant who has actually increased his firm’s exposure to commodities with a view to taking advantage of the tactical and technical story that’s currently driving them.

“We want to have exposure to the more market-driven investment story,” says Wright, whose firm invests in commodities through a variety of different investment vehicles, including mutual funds and ETFs of commodities futures. “Given that commodities are at a very speculative and inflective point right now, we want to play them from a trading-oriented perspective. We’re looking at the technical flows and trends and taking a long/short approach, because commodities are trading on a lot more than just fundamentals right now.”

According to O’Rourke, a long/short, actively managed strategy is the best way to invest in commodities and take advantage of the technicalities in the market. The asset class does offer equity-like returns, he says, but it is also cyclical and tends to revert to the mean, which means that a long-term, long-only strategy doesn’t give an investor the same kind of benefits as a more directed and active approach.

Direxion’s commodity mutual fund is made up of six different commodity sectors and 16 different commodities including energy, grain, livestock, precious metals, industrial metals and “softs” such as coffee, cocoa and sugar. Each sector moves independently, O’Rourke says, and the fund will take either a long or short position in each sector on a monthly basis, depending on what sort of dynamic the sector is experiencing.

“This kind of active management allows us to capitalize on trends and whether they’re going upwards or downwards,” he says.

Forward Management’s $31 million Forward Commodity Long/Short Strategy Mutual Fund, which was only launched last December but has been garnering a great deal of interest since inception, uses a momentum filter and a volatility filter to determine how it’s going to position itself in the various sectors it’s invested in. A high momentum with decent volatility would result in a long position, while strong negative momentum would mean a short position, Rowader says.

“This management style allows us to deliver positive returns but also protect on the downside, which many long-only commodity funds can’t do,” he says. “While it’s important for people to understand the long-term, macro theme behind commodities, and how the continued industrialization of the emerging markets will propel commodity prices higher, it’s also important to know that there can be corrections in the short term, so having a strategy that can adapt to market conditions is superior because it allows for flexibility and it will be able to preserve capital.”

Most commodities investors advocate an actively managed approach to the asset class because extracting the most from commodities means being able to deftly rotate between sectors and sub-sectors, Guinness Atkinson’s Riley says. But Riley is also quick to underscore the difference between active trading for short-term gains (a strategy that is very much in vogue right now, he says) versus active management for long-term returns. The latter, he says, is where it’s really at with commodities, even for investment vehicles and strategies that are focused on a single commodity such as oil.

“Unlike many today who are active traders looking to make quick trading calls, we are long-term investors who are more interested in finding cheap and attractively valued companies that we can own for two or three years,” Riley says. “If you believe, as we do, that rising oil prices and rising natural gas prices [will continue], this long-term strategy works well.”

Riley believes that the growing demand for oil, in particular from emerging market countries, will outstrip supply, and this will continue to force oil prices up. The events in North Africa have also acted as a catalyst for oil prices, he says, but the best way to take advantage of this trend is to invest in a fund that looks at the dynamics as part of a long-term story.

The Guinness Global Energy Fund is focused on long-term capital appreciation by investing in companies that span the entire energy industry, Riley says, from companies that are engaged in the production, exploration, discovery or distribution of energy, to those that are involved in the research and development of alternative energy sources. This kind of diversification, coupled with hands-on, active management, allows for a full-breadth exposure to a long-term, commodity-based investment theme.

According to Fred Sturm, portfolio manager of the Ivy Global Natural Resources Fund, there is a danger in embracing commodity investment products as short-term and tactical tools. The risk, he says, is that trading the short-term swings often means investors will lose sight of the bigger picture that allows them to capture the long-term return.

“Investors in the resources space need to decide for themselves whether to be aggressively tactical and say, for instance, ‘I want gold today,’ or to approach this asset class from a more diversified perspective,” Sturm says. “Ivy Global Funds invests in commodities in the broadest possible way, and as a long-term investor in resources, we believe that it’s important to include all commodities from energy—which means producers, service companies, renewable energy and so on—to agriculture companies, precious and base metals, forest products and so on.”

In the name of diversification, many investors believe that an allocation to a single commodity sector will do the trick. But this can be detrimental to a portfolio, Sturm says, because an individual market can change colors very quickly and trend fast into negative territory.

“You may think, for instance, that given the great demand for base metals, all of them will be at record highs, but while copper is, zinc isn’t, so you’d have done wrong by going with that very targeted approach,” Sturm says.

There is certainly a market for highly specialized products, but investors who get into them need to really do their homework first, he says. For most people looking to get into commodities, a broad-based and diversified investment strategy that encompasses all commodity sectors is really the best way to go, he says.

“The broadest possible way to invest in commodities, by sub-sector and market geography, yields the best results,” Sturm says. “In a fund like ours, we can’t, for example, keep up with gold funds if gold is all the rage, but we can overweight the sectors that the market may favor at any given time. This is what makes the difference.”    

Savita Iyer-Ahrestani is a freelance writer and regular contributor to Investment Advisor and AdvisorOne.com based in New Jersey.

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