Stockpiling Commodities

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.

Today, 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.