Commodities: the new asset class?

4 October 2004

The following article has been reproduced with the kind permission of Mark Mathias, Managing Director of Dawnay Day Quantum (a UK based Investment Manager who produce structured retail products).  DDQ have just launched the first retail commodities fund in the UK.  Its structure is very similar to the Liontamer COMBIgrow 100+ fund which launched in April this year.

Mark Mathias, MD, Dawnay Day Quantum
Mark Mathias is MD of Dawnay Day Quantum, who launched the Dawnay Day Quantum Protected Commodities Accelerator today; here he makes the case for structuring products with a commodities underlying.

The basic theory of portfolio investment is well captured by the old cliché, "Don't put all your eggs in one basket". Different assets perform differently at different stages in the economic cycle. If we were clever enough to know which the top-performing asset was going to be over the next six, 12 or 24 months, portfolio theory would be useless. The best response would be to invest everything into this one asset.

Sadly, we all know what we think the best performing asset will be, but that's where it stops.

The story so far
Most private client portfolios, whether discretionary or advisory, have traditionally been structured around equities, bonds and cash. Until the 1990s, growth portfolios tended to hold a mixture of equities and cash, and income portfolios held a mix of high-yield equities, bonds and cash.

As the recent bear market started to bite, yields fell and bonds became the best performing asset class from the traditional mix. Growth investors were suddenly prepared to consider bonds in the normal portfolio mix. Falling yields also drove performance in property. As the yields from rental property started to look attractive, prices rose –chasing yield.

Suddenly property became the most attractive asset class. Alongside the tale of woe for equities, the hedge fund industry had been making its case powerfully for inclusion in high net worth private client portfolios. As well as the theoretical arguments for diversification of risk, hedge funds had made that strongest of all arguments –good performance.

So, the last five years have seen the recognised assets in a private portfolio multiply from equities, bonds and cash to equities, bonds, cash, property and alternatives. These have also come to include VCTs, private equity funds, and in the more exotic cases, wind farm investments, fine art, stamps etc.

One thing is common to all the new asset classes; they only fought their way onto the list when they could demonstrate periods of strong absolute and relative performance.

What about commodities?
In order for commodities to become a potential new asset class, capable of inclusion in portfolios, the investment needs to fulfil three main criteria:

• Offer exposure to a new underlying asset class whose returns are not correlated to the traditional equities, bonds, cash mix
• Enhance the risk reward profile of the portfolio as a whole
• Most importantly –have the distinct potential to outperform other assets in the immediate term

A new asset class?
Commodities are self-evidently a different asset class from equities and bonds. The investor gets exposure to physical assets. Market prices are driven by short-term supply and demand with little reference to long-term valuation criteria. Studies have shown that commodity returns based on the Goldman Sachs Commodities Index (GSCI) are negatively correlated to equities and bonds: See Table (Source: Barclays Capital; Data from Jan 1970 to June 2004).

Even the correlation to cash returns are very low, giving this asset a definite claim to being a separate asset class. The return profile is also markedly different from equities, bonds and cash because all these produce some element of dividend or income stream, which commodities do not. Instead commodity returns come solely from capital appreciation, which explains their high volatility.

Better portfolio risk/reward?
Analysis of a portfolio of equities and bonds showed that the efficient frontier of returns could be substantially enhanced by adding exposure to the GSCI —and this despite the fact that equity and bond investors forego income when investing in commodities.

Many investors claim to gain their exposure to this area via commodity related equities such as Shell, RTZ, BHP Billiton. While these companies do offer some exposure to commodities, the claim of a separate asset class is that such a proxy does not do the same job. Studies have shown that the commodities-related shares of the S&P 500 do not capture all the rises of a commodities index. Equally, the equities showed about 45% correlation to the S&P500, thereby losing a lot of the diversification benefit of a direct commodity investment.

Clearly, the lack of correlation of returns and the ability of commodities to show positive returns in periods when other assets are falling makes them a valuable asset to a portfolio. The Barclays Equity Gilt Study 2004 concluded that balanced portfolios should hold near to 10% of their assets in commodities, based on the data of the last 30 years.

Positive price performance
And now to the crux: are commodities likely to give beleaguered portfolio managers a positive real return while equities and bonds are coming under pressure at the same time? We are not alone in believing the answer is 'yes'.

The chart (Source:www.ditomassogroup.com) illustrates that commodity prices move in clear long-term cycles, and that although many people think commodity prices are near to their highs, in fact real commodity prices are near to their all time lows.

Commodity prices are basically driven by supply and demand. After many years of falling real prices, both the demand and supply side of the equation appear to be well poised.

The demand story is driven by world demographics and rising GDP. Key elements to the demand side are:

• Chinese consumption of commodities is rising rampantly
• Despite being a large consumer of commodities, the per capita consumption of commodities in China is very low and has potential to rise dramatically
• There are over 1bn people in India who are starting to awaken to consumption, but are behind China in the development race
• Global GDP is forecast to more than double between 2000 and 2025. This equates to a huge increase in commodity demand

The supply side shows the opposite picture. Following years of falling real prices, infrastructure investment in commodities has been woefully inadequate.

The lead time between the decision to expand commodity supply and the actual delivery of new capacity is measured in years. Sinking new mines, building pipelines and new smelters or refineries are all activities with long lead times. In the meantime, the only factor that can bring demand and supply into line is price. We have seen the start of this trend. Commodities prices have been rising for the last 18 months or so. The chart shows that we are still early in the cycle.

Overall, the fundamentals are telling us that the demand and supply situation for minerals that need to be extracted from the earth are looking very positive indeed for investors.

What next?
Forward looking portfolio managers and advisers have already realised that commodities are an asset ripe for inclusion in portfolios. Given the economic cycle, they are ripe for inclusion now. However, it takes a long time before the consensus gathers around the opinion leaders.

My guess is that the smartest advisers will be investing in commodities now, while the greatest excess returns are available, and including the holding under the 'alternative investments'or 'other'holdings. The crowd will wait until there is a category called commodities. They will still reap the benefits of diversification and a commodity cycle that extends over a relatively long period, but the excess returns will be the reward of the early birds.

For more information, please visit: www.dawnaydayquantum.com