Whether gold or silver, or oil or copper, commodities have been hugely popular alternative investments that advisors have been buying in hopes of enhancing portfolio performance. However, unlike stocks and bonds, commodities are among the most challenging investments in which to gain effective exposure.
This point was driven home at last December's Commodities Conference in New York City by Matt Hougan, president of ETF Analytics at Index Universe. He cited the performance of two funds: the iShares GSCI Commodity-Indexed Trust (GSG) and the Green Haven Continuous Commodity Index Fund (GCC). Over the past three years through mid-December, Hougan said the $1.3 billion GSG fund was up 15%; the smaller and far less known GCC, with $600 million, was up a cumulative 40%.
Hougan's point: investors and advisors really need to do their homework to generate superior returns. Indices, on which many commodity funds are based, can be widely different from one another. The GSCI Index, for example, has 70% energy exposure. The Dow Jones-UBS energy exposure is 35%.
Some advisors gain commodity exposure through futures contracts, which have their own dynamics that can erode or enhance the underlying value of commodities. When relying on equities, commodity shares include a strong component of the broad market, meaning that you're buying equity beta as well as the particular commodity.
And if all this isn't complicated enough, there is no established consensus for what defines a bona fide commodity portfolio, the way in which many investors accept the S&P 500 as the equity benchmark to beat. With no agreed upon standard, explains John Hyland, chief investment officer of the United States Commodity Funds, it's awfully difficult to gauge how well a manager's commodity investments are actually doing.
Investing in the sector has been made even more challenging during the recent slowdown in global growth. This has sent many commodity prices and commodity funds tumbling in 2011. And it begs the question: Should advisors continue to seek commodity exposure in 2012?
According to Michael Lewis, global head of commodities research at Deutsche Bank, "since super-cycles in commodity markets typically last up to 20 years, one could argue that we are only halfway through the current one. However, the ability of commodity prices to push higher in 2012 is not certain."
Data from Morningstar doesn't make a clear case for commodities either. The average return for commodity funds over the past year through December 21 was -5.89%, while total returns for the S&P 500 were up 1.21%. Over the past three years, the broad market turned in annualized returns of 14.37%, outpacing commodities by 3.36%. And going back five years, inclusive of the financial crisis, equities are down 0.47% annually, more than two full percentage points greater than commodity funds.
Lewis explains that there are currently several major obstacles to rising commodity prices. They include the Federal Reserve figuring out how to stimulate growth, China being able to engineer a soft economic landing and European policymakers finding an effective solution to their sovereign debt crisis. The implications of collective failure across these fronts on global growth and world commodity demand, he posits, would be bleak.
JP Morgan's lead commodity strategist, Colin Fenton, is positive about the 12-month outlook. He thinks the "near-term economic damage will likely force a significant policy reaction that [would] establish the necessary floor for the next commodity advance."
Mihir Worah, a Pimco managing director and head of the firm's Real Return Portfolio with $22.3 billion in assets, has a middle-of-the-road view. While he believes in the long-term merits of commodity investing, especially as a hedge against inflation, he is cautious about 2012. With inflation likely to be muted, Worah doesn't see any clear drivers for a sector rebound over the next 12 months.
He does, however, see potential causes for commodities to temporarily spike. If the Arab popular movements trigger national or regional turmoil, global oil markets would push up the price of oil. An air strike on Iranian nuclear weapons facilities would do likewise.
Worah does see several investment opportunities that don't depend on exogenous events. He likes platinum. "It shares several similar qualities with gold," he explains, "including being a precious metal that has a store value and some industrial use."
Platinum typically trades between 5% and 20% above the price of gold. But it's now selling 10% below gold as widespread investor demand has sent the price of gold soaring. Worah believes that trend, at least over the near term, is reversing and platinum should subsequently regain its higher-priced status.
Darwei Kung, co-manager of the $1.12 billion DWS Enhanced Commodity Strategy, thinks this may be accomplished through the further decline in gold prices. Without significant new demand for the precious metal, Kung thinks gold will trend lower, especially if the flight to the U.S. dollar and Treasuries continues. "Gold tends to move inversely to the value of the dollar," Kung says.
Scott Wolle, chief investment officer for global asset allocation at Invesco, however thinks gold will rally in 2012. He bases this sentiment on the likelihood of further easing in monetary policy in both developed and emerging markets. He believes this will ultimately weaken the value of currencies and propel investors into commodities that serve as currency alternatives. This pro-gold stance is evident in the firm's Balanced Risk Commodity Strategy, which has $1.1 billion in assets. Held in both its core and tactical holdings, gold represents one-third of the strategy's holdings versus less than 14% of the Dow Jones-UBS Index.
On the agricultural front, Jerome Abernathy, portfolio strategist for alternative investments for the $380 million Rydex/SGI Long-Short Commodity fund, thinks corn could be a compelling short. U.S. ethanol production now absorbs about 40% of U.S. corn output. Abernathy argues that if U.S. auto emission regulations are relaxed in concert with U.S. government spending cuts, then U.S. subsidies, which have propelled ethanol creation, may be substantially reduced. Corn prices would then likely fall.
Worah thinks that declining oil refinery capacity in the New York metropolitan area should eventually lead to higher local gas prices as measured in the RBOB gasoline futures contracts. "Local refining capacity was 1.7 million barrels in 2007," says Worah. In response to declining demand, he expects that figure to fall to 800,000 barrels in 2012. He surmises, however, that this will result in localized supply shortages, eventually sending prices higher.
Worah is also watching natural gas. While it enjoyed a run-up in the aftermath of the partial nuclear power plant meltdown at Fukushima when Japan turned to alternative energy sources to power the nation, the broad expansion of natural gas supplies has been pushing down its price. But he believes demand for this clean, affordable and abundant energy source will eventually catch up with supplies and send its price higher.
The prices of leading industrial metals such as copper and aluminum have been hit as global growth has slowed throughout 2011. But Darwei Kung thinks they could rally in the second half of the year. "Copper lost 25% in 2011," he says, adding that it may continue to decline in first half of 2012. "But if the euro zone can avoid a full-blown crisis and regional growth is re-established, then we could see this and other industrial metals begin to rally off these relatively low prices."
Among the most unorthodox contrarian plays is uranium. Following he disaster at Fukushima and the subsequent political fallout across many Western markets, there has been a push to decommission nukes and re-evaluate the national policy commitment to nuclear power. This sent the spot price of uranium tumbling from $72 to $42 a pound, according to Marshall Berol, a co-portfolio manager of the Encompass Fund and separately managed accounts worth nearly $300 million. The price of uranium has since moved up beyond $50, and Berol thinks the price will return to pre-crisis levels.
"Existing power plants and those that will come online in the next few years will require 180 million pounds of uranium," explains Berol, "which existing supplies will have a problem meeting." So he expects higher rates will be necessary to promote more mining. And he believes that investors, who left the market after the Japanese disaster, are now returning. Berol believes their speculation will further drive marginal demand.
China And Emerging Markets
While the large economies of U.S. and Europe make up core demand for commodities, expanding emerging market growth directly affects spot and futures prices. And there is virtually universal agreement that prices in 2012 will be greatly influenced by what specifically happens in China, India and Brazil-leading edges of commodity demand.
Deutsche Bank's Michael Lewis says that Chinese growth is slowing, but not precipitously. According to November data, copper imports to China, a key metric of growth, expanded for the sixth successive month and has reached a 20-month high.
Scott Wolle of Invesco echoes the sentiment of many observers who believe that even if Chinese growth does slow significantly, local officials will seek to stimulate expansion by reducing minimum bank reserves. This would free up more lending capital.
DWS' co-fund manager Kung agrees that key emerging markets will shift to more pro-growth policies to offset stagnant demand from the euro zone and the U.S. This has been evident in Brazil, he observes, where there have been three straight interest rate cuts, bringing the overnight rate down to 11%, despite inflation running more than 6%. He also points to the recent relaxation of taxes on foreign equity inflows into Brazil from 6% to zero, which was instituted in response to the inflow of hot money and the subsequent rise in the real-a concern that is no longer an issue.
Equities Versus Futures
As mentioned above, many commodity funds track indices through the purchases of futures contracts, which are quite different investments than shares of leading global mineral producers Freeport McMoRan or BHP Billiton. Futures contracts provide more pure commodity exposure, but with potential downside based on the way contracts function. Mining companies provide exposure to a more familiar investment. But such commodity shares come with exposure to corporate management and operational risks, as well as to broad market sentiment.
Xiaowei Kang, director of global research and design at Standard & Poor's, found that "historically, real asset- and commodity-based equities have significantly outperformed core equities and commodity futures, respectively, and have also provided inflation protection and portfolio diversification."
Pimco's Worah disagrees, claiming that commodity stocks carry broad market performance risk and that the desired characteristics of commodities-specifically uncorrelated returns and an inflation hedge-are more completely achieved with futures contracts.
Ruy Ribeiro, a cross-asset strategist at JP Morgan, thinks there's a hybrid solution. He sees advantages of buying quality stocks that pay dividends, grow and have no rollover costs associated with the renewal of futures contracts. But he agrees they are not as closely linked to commodity prices as futures are. So he argues for "dynamic switching between commodity futures and equities on the basis of their relative yield."
For advisors who decide commodity exposure is desirable, either in the form of individual stocks, equity funds or futures-based commodity funds, monitoring results is a must. But to do so meaningfully, it's also critical to identify a relevant benchmark. Otherwise it will be virtually impossible to discern whether one's performance has been worth the risk or if there are other non-commodity investments that can achieve superior returns with less volatility.