17 Sept 2006
News to get you going: The California Public Employees Retirement System (or CalPERS) has committed their members to increasing their investment in natural resources.
In Schwarzenegger Land this is either an example of "Hollywood hype" like the ugly duckling to beautiful swan; or CalPERS are demonstrating that commodities as an asset class is about to become mainstream.
If the latter is the case there is a need for investors to become more aware of the asset itself, and a need for investors to become more aware of the indices that benchmark performance.
"Ugly duck?" I hear you say. When I was growing up, commodities were seen to be an investment tool for holding against unpredictable inflation rather than something that investors scrambled to for growth.
Certainly, it was rarely used as a strategic asset class within portfolio management. In the 1990s this was justified by uncompetitive performance against equities, bonds and the alternative strategies.
But then came the 21st century. I stopped growing up; oil and gold went boom; and the duck became a swan, especially for those that were "in it" from 2000. Even though we have seen recent slumps in oil and precious metal prices, the trend, it seems, is one of unmitigated upwardness.
Oxford Club
The Oxford Club (an investors club) reckon that Chinese demand will fuel natural resources returns for another 10 years estimating that Chinese demand alone will increase by 1,761 per cent very shortly. Even though the Saudis have estimated that we are only tapping
into 18 per cent of the world's oil stock, there are enough bulls like the Oxford Club currently playing in the field.
"Commodities" is, of course, a huge school split into five classes: energy, grains, metals, food and fiber and livestock. Star pupils are the headline makers like gold and oil.
'Ask Jeeves' gave me the definition that a commodity is "something whose market value arises from the owner's right to sell rather than the right to use". That's quite broad though, for investment definition purposes why not add "natural and found in large quantities". Is this good enough to be called an asset class, or put another way, why would CalPERS make a strategic investment decision into natural resources?
Here are three thoughts as to what constitutes an asset class, and why, as a result, commodities make a good diversification tool within an investment portfolio.
Thought One: returns are independent and bear a low correlation to other asset classes. It's odd that tension and disasters created by the weather or politics often has the effect of hurting equities and bonds, yet they have a positive effect on commodities.
Thought Two: prices have been positively correlated to inflation. In short, commodity returns are superior to cash.
Thought Three: it is difficult (impossible?) to re-create the returns on commodities by tracking other assets or by mixing other assets together.
Yet, by mixing commodities within a portfolio, the portfolio will be diversified as the commodity component will produce different results than everything else.
OK. So, how will we measure the performance of the fund managers or advisers we use? This is not an easy question to ask either Jeeves, or seasoned city traders. The views are varied and largely depends on which star pupil you want to weight your portfolio towards. But we must start somewhere. So here goes, five indices to consider.
Index One: The London Metal Exchange (LME), great for metals, but as it lacks three of the five commodity classes it's hardly an adequate benchmark for the school as a whole.
Index Two: the Commodities Research Bureau (CRB). One big weakness is that it weights commodities equally. This means that orange juice is given the same weight as oil. We all know they taste different, but oil also has an economic significance of some 50 times greater than OJ.
Index Three: Goldman Sachs Commodity Index (GSCI), this was favoured by a couple of fund managers I asked. It contains about 25 commodities and was recently weighted some 70 per cent towards energy largely driven by the recent spikes in prices. Grains constituted 11 per cent and industrial metals 18 per cent. The weighting is based on a five year moving average of world production.
Re-balanced annually
However, the portfolio is re-balanced only once a year. One school of thought in the commodity world is that indices that are re-balanced monthly will outperform those re-balanced annually by about two per cent per annum.
Index Four: The Dow Jones-AIG (DJ-AIG) restricts weightings to 33 per cent. Again the index is re-balanced annually and the weighting is influenced by liquidity data (specifically, the amount a commodity is traded).
Index Five: The Rogers Raw Materials Index. This accesses over 30 commodities; it is re-balanced monthly, and weighting is selected according to their weighting in international commerce. This index scored quite highly in the views of a number of other fund managers I spoke with.
What we get from this is that, for now, measuring performance against indexes remains awkward. All these indices will provide different results because of the way they have been constructed.
It remains important to select benchmarks as Zig Ziegler said: "if you don't have a target what are you aiming at", although for now, many investors see the world of commodities as a swan simply because it provides an alternative beta and a significant diversification opportunity.
The writer is the managing director of Mondial (Dubai) LLC.
By Sean Kelleher
Gulf News 2006. All rights reserved.
