The case for commodities

When investors talk about commodities, it is actually a diverse group of assets they are referring to in that catch-all term.

Funds investing in commodities may be positioned in anything from oil to precious metals such as gold, silver and platinum, and to agricultural crops, including coffee, wheat and corn.

Perhaps the most well-recognised commodity and one that investors may be most familiar with is oil.

James de Bunsen, a portfolio manager on Janus Henderson’s UK-based multi-asset team, acknowledges the asset class is “a diversified bunch of underlying commodities”.

He says: “To lump them together may be a bit spurious but it’s just for ease.”

Supply and demand

When discussing whether there is a long-term case for having exposure to commodities in client portfolios then, it is worth bearing in mind not only the different types of commodities within an allocation to the asset class, but also the varying drivers affecting their price.

“They all have their own supply and demand dynamics, so what’s relevant for oil is probably not so relevant for wheat, or copper,” Mr de Bunsen points out.

With precious metals, copper and platinum, for example, have industrial uses that affect the price of these commodities, while gold prices are typically linked to central bank buying and demand for gold jewellery in India and China.

“There are a couple of things that do link them and that’s they’re all denominated in dollars. So all things being equal, if the dollar goes up, that puts a bit of pressure on commodities and vice versa,” he adds.

For many investors, the role of commodities in a portfolio is to act as a diversifier.

Most commodities are uncorrelated to equities, which is what makes them a useful diversification tool.

But Philip J Milton, managing director and investment manager at Philip J Milton & Company, cautions: “I cannot say I should just buy commodities as an ‘alternative’, as if they are up with economic events too, then they’d all fall the same [direction] as equities anyway.

“Of course, it would be naïve to imagine that all alternative assets (save perhaps precious metals as real alternatives) would be protected, or indeed work in the opposite direction to equities.

“But sometimes it can be just a case [having] exposure to some uncorrelated assets, which have properties that are different [to those of equities or bonds].”

Mr Milton's point about commodities and equities moving in similar directions at times is reflected in the latest volatility data for both asset classes.

In its 2018 mid-year global market outlook, Bill Street, head of investments EMEA at State Street Global Advisors, warns commodity volatility has resurfaced as market volatility more generally “has returned to normal levels”.

He also points out inflation is “trending higher”, although he goes on to forecast this will remain contained for the rest of the year.

Mr Street warns: “Commodity price jumps pose more immediate risks to inflation.”

Inflation protection?

This may seem odd, as the asset class can often act as a form of inflation protection.

Mr de Bunsen explains this is the other shared trait commodities have.

“Sometimes they can cause inflation, particularly in emerging market countries – food is a big part of the underlying inflation indices and still a big part in the developed world,” he notes.

“Commodities can cause inflation but also if people feel there’s inflation out there or inflation coming, then the prices can react ahead, it can front-run actual inflation numbers because people assume that commodity prices are going up.

“In a way you can, to a certain extent, see this as a reasonable asset class to hold if you expect there to be inflation.”

Gold, in particular, which is often referred to as a ‘safe haven’, is known for being a hedge against inflation, specifically US dollar inflation.

Matt Tagliana, head of ETF products at Invesco, confirms gold’s role as a safe haven asset is well established and that it continues to serve this purpose today in investors’ portfolios.

“This is unlikely to change, as one of the basic results of modern finance is that adding additional diversifying assets to a portfolio allows investors to achieve a better risk-adjusted return,” he suggests.

“So, unless gold became very highly correlated with stocks or bonds, it would still have a place.”

He continues: “As for replacing gold with other commodities, it’s not really a like-for-like substitution.

“Gold is viewed as a currency proxy and inflation hedge and its price is impacted by different factors and in different ways than, for example, energy products such as oil, or a base material like copper, or an agricultural crop like wheat.”

This brings investors onto how to get exposure to commodities in their portfolios.

There are numerous ways to allocate to commodities – and that’s not just the usual active versus passive exposure, although that does apply, of course.

Some investment funds will give investors equity exposure, while others will allow the investor to hold the physical asset, such as gold bars.

Mr Tagliani comments: “While they all fall under the broad heading of ‘commodities’, substituting one for another is really a fundamental shift in your exposure.

“For this reason, many investors looking at commodities choose to use broad-based commodity products to get diversified exposure to the whole space.”

In July, Lazard Asset Management launched a Global Commodities fund investing in commodities and commodity-related equities in order to “access a broad universe”.

The fund is managed by the Lazard commodities team, led by portfolio manager and analyst Terrence Brenna.

In the accompanying press release, he says: “Our investment philosophy is based on value creation through fundamental analysis of commodity futures and related equities, including meaningful ESG [environmental, social and governance] considerations.”

Equity risk

Some investors may not be comfortable with having so much exposure to commodity equities however, given that the asset class is meant to be uncorrelated to equity markets and equity markets have performed strongly over the past few years.

Mr de Bunsen notes: “I think the problem is what you’re getting is a lot of equity risk [when holding a fund] which might take away from the fact, in some people’s minds, they’re buying commodities because they’re hoping for a diversifier.

“I think there are some times when buying commodity stocks is a better thing to do because of the valuation or whatever. But at the same time, what you shouldn’t expect is for them to be necessarily uncorrelated to the other things in your portfolio.”

He adds: “They are, after all, equities. If the equity market falls 20 per cent, it’s pretty likely they’re going to do something similar.”

For those clients who specifically want an allocation to gold in their portfolio, it is unlikely they will get that via an actively managed fund.

Mr Tagliana observes: “Gold represents a larger portion of total ETP [exchange-traded product] assets than would be expected based on the allocations most investors make to gold in their portfolios.

“This suggests investors find ETPs are an attractive means of gaining exposure to gold, as opposed to direct investment or commodity futures. The ongoing competition between issuers offering gold ETPs means that the fee levels on these products are quite reasonable.”

Asset allocation

So are advisers allocating to commodities in client portfolios?
And are managers using commodities as a hedge, given the inflationary environment?

“Yes, we have introduced some commodities to strategies to try to select alternative defensive assets to bonds, which may prove to be the most defenceless assets of all time if or when interest rates start rising,” Mr Milton explains.

“We have tried to use ‘cheap’ and staple commodities too, so when you look at, say, wheat and agricultural products, these are pretty low historically – the theory being that we’ll still be eating despite the financial affluence we may or may not feel.”

But some financial advisers view commodities as a speculative investment and do not recommend these assets for client portfolios.

Dennis Hall, chief executive of Yellowtail Financial Planning, says they “simply add a higher level of speculation to the portfolio”.

Joshua Gerstler, financial adviser and company director at The Orchard Practice, refers to gold specifically as “a punt”.

“I believe that gold is a speculation not an investment,” he reasons.

“Shares should provide you with dividends and property should provide you with rental income. Gold provides you with nothing.

“When you buy gold you are doing so in the hope that someone will buy it from you in the future for more than you paid for it.”

But for many portfolio managers, gold has a valuable role to play in their funds, as a hedge against overblown markets, for example, or a weakening dollar.

Tilney recently announced it was halving its exposure to physical gold across its central investment strategies, including its Multi-Asset Portfolio range which comprises seven funds, having initiated its investments in the asset at the end of 2015.

Ben Seager-Scott, chief investment strategist at Tilney, explains the gold trade “has served portfolios well, especially as we moved through a period where markets have been driven more by liquidity than fundamentals”.

“With the investment landscape changing, it seems appropriate to review these positions, and begin taking profits. The gold positions effectively substituted for distorted fixed income markets which are now close to normalising in the US.”

Mr Seager-Scott confirms that “with gold having done its job, now we can start returning to a more traditional footing”.

“In place of gold, we have increased our positions in short-dated US Treasury inflation-protected securities, which we believe will still offer some portfolio protection during risk-off periods,” he notes.

Meanwhile, Lazard Asset Management launched its commodities fund due to what it believes is investor demand.

Tony Maddock, head of third party distribution at Lazard, says: “With increased concerns about duration risk and rising inflationary pressures, it is important for our clients to have the right commodities exposure within their portfolios.”

eleanor.duncan@ft.com