Copper Bottomed

Commodities have been arguably the biggest investment story of the last five years yet few pension platforms offer the asset class as a core option. Paul Farrow examines what role commodities should have in a pension portfolio and whether a bubble is about to burst

It was only a couple or so years ago that experts were urging pension funds to increase their exposure to commodities and make the most of the boom.

Back in 2005, Europe’s largest manager of pension assets, BGI told an NAPF conference that pension funds should invest in commodities such as oil, gold and copper. And many did just that. Those that have ignored the natural resource boom may be cursing their luck. The sector has gone from strength to strength with the seemingly ever rising oil price playing its part. To give you an idea of the returns, the JPM Natural Resources fund – one of the few in existence – has climbed by 490 per cent over the past five years.

The price could go higher – much higher even. Opec president Chakib Khelil of Algeria has speculated about crude hitting USD200 a barrel, while some analysts reckon that USD250 is not far off the mark.

But after a rush of new cash at the start of 2006, including funds from major institutions, and a more hesitant beginning to 2007, evidence suggests that the money is not in it for the duration.

“About a year ago, we came to the view that market conditions no longer made investment in commodities that attractive,” says consultant Alasdair Macdonald, at Watson Wyatt, who suggests that high prices have left some commodities vulnerable to a correction.

There is certainly a view that a correction in the sector is imminent, with some analysts drawing parallels with the technology boom. They fear the worst.

“A sudden surge in oil prices has dominated the headlines over the past weeks and the run up over the past few years is eerily similar to the surge in the Nasdaq index in the late 1990s. Back then we were told things were different because of the arrival of the internet. Traditional valuations didn’t apply any more. Now the surge in energy prices is being justified by demand from emerging Asia and low interest rates, even though the reason interest rates are so low in the US is because the financial system is in a complete mess and the economy is in recession,” says Paul Ashworth of Capital Economics.

Ashworth notes that it is notable how many times in history a period of easy money and credit availability have set off a series of booms in stocks, property and often commodities as well, all at around the same time. “Now that the latest bout of easy credit has come to an abrupt end and housing is bust, the bubble in commodities is the next one to watch,” he adds.

Graham French, the long-standing manager of Mandamp;G Global Resources is not predicting a wild correction but he is concerned that valuations among natural resources stocks have gone too far. He says that the strength of global commodities demand, in particular from industrialising countries, has resulted in very pronounced rises in the share prices of many natural resources companies in recent years.

“While I expect this demand to remain robust in the long run, I believe this scenario has left company valuations in a number of cases looking quite stretched. As such we have been reducing the natural resources weighting in the fund over the past year or so, while at the same time retaining significant exposure to those mining companies with strategically valuable assets where expectations of future returns are not excessive.”

But on the other hand, Ian Henderson, the fund manager of the leading JPM Natural Resources fund remains sanguine. “Commodities are a great hedge against inflation. We see so many corrections and we probably are due one today. I suppose the oil price could fall 20 per cent but the story remains strong – although it will not go up in a straight line, returns should be strong.

“Many analysts underestimated the effect of the oil price on companies’ performance. Even if it falls back to USD100 a barrel, they still look good value. In fact, I find it hard to believe that the oil price is overvalued – the sector is on average earnings of around 7 while even BP is on an average of 9.5, which is not demanding.”

Whether now is the optimum time to be investing in the commodity sector is questionable. For every Graham French, there is an Ian Henderson – but the argument for investing commodities over the long-term looks indisputably compelling. According to the latest World Energy Report the emerging nations – notably China and India – are going to continue to support and fuel energy prices for the next two decades.

The report reveals that the world’s primary energy needs are projected to grow by 55 per cent between 2005 and 2030, at an average annual rate of 1.8 per cent per year. Demand of oil equivalent will reach 17.7 billion tonnes compared with 11.4 billion tonnes in 2005. Fossil fuels remain the dominant source of primary energy, accounting for 84 per cent of the overall increase in demand between 2005 and 2030. Oil demand reaches 116 million barrels per day in 2030 – 37 per cent up on 2006.

It does not stop there. In line with the spectacular growth of the past few years, coal is predicted to see the biggest increase in demand in absolute terms, jumping by 73 per cent between 2005 and 2030 and pushing its share of total energy demand up from 25 per cent to 28 per cent.

Most of the increase in coal use will arise in China and India, while the share of natural gas will increase more modestly, from 21 per cent to 22 per cent. Electricity use is predicted to double, its share of final energy consumption rising from 17 per cent to 22 per cent, according to the report, which concludes that some USD22 trillion of investment in supply infrastructure is needed to meet projected global demand.

Anthony Eaton, of JM Finn, the boutique fund manager, says: “The recent spikes in energy and food prices highlight how stretched global infrastructure is in meeting just the needs of western economies never mind the 80 per cent of the world’s population living in non G7. This is a global phenomenon and is likely to build in relevance going forwards if current forecasts prove anywhere near accurate.”

He points to a report from PricewaterhouseCoopers that believes that China should be able to sustain an average growth rate of around 6.8 per cent per annum in real dollar terms between now and 2050. India should be able to sustain 8.5 per cent and Vietnam 9.8 per cent.

“On that basis China’s economy, at present less than a quarter of America’s at market exchange rates, will, by 2050, be 30 per cent bigger and nine times larger than our own economy. India will still be smaller than the US but will be seven times the size of Britain. We, in the West, will still be roughly twice as rich, per head, as China but the gap, by then, will be closing fast. Given that there are around 1bn people in each of China, India and Africa, the implication is that there is plenty of demand for basic goods, commodities and primary industries.”

This long-term argument is why Investec have launched its Global Resource Enhanced – a fund that it says will be winging its way onto DC platforms soon. Investec believes there will be a 15-year secular bull market in commodities – again driven by China, India and other developing countries as they urbanise and change their buying and dietary habits.

“The capital expenditure of these companies shows no sign of abating,” says David Aird at Investec. “On average capital expenditure should rise by 2009 to a level of USD21 per barrel produced, compared to USD16 per barrel for 2007. Gazprom has announced an increase in capex of 40 per cent in 2008 to USD28bn. ExxonMobil announced a 28 per cent increase in capex over the next five years, representing a further USD25bn in spend – I could go on.”

The difference with the new Investec fund – and why the South African owned company reckons it will be proved a winner – is that it has embraced full Ucits III powers. Or put it another way – it can hedge against price falls – and one of the concerns of specialist funds is that they can be volatile, which may not suit pension investments.

“There are more than 40 commodities from base metals to energy to soft commodities such as agriculture. The new fund means we can now hedge against falls, whereas long only funds can only benefit from rising prices. It means that investors only have to take on half the risk – that has to be attractive to a pension investor,” says Aird.

“This is the big mistake people make – they think that all commodities have been riding with the tide, but that’s wrong. Metals such as zinc, copper and lead have all underperformed of late – and that commodities are not a homogeneous set.”

Aird reckons that there is an ‘insatiable’ demand for global energy products. In reality there are few specific natural resources funds out there. The well-known funds include JPM Natural Resources, BlackRock Gold andamp; General and Investec Global Resources all feature on a dozen or more platforms – but demand from group business remains slow.

Colin Williams, executive director of DC Business at Fidelity International, admits that demand for commodities and natural resources funds remains minimal to low from DC members and sponsors. That said, he does believe that will change – for two reasons.

Firstly, as trustee boards become more accepting of alternative assets he expects more specialist funds to be placed on platforms for members to select – this is likely to happen first at those schemes where trustees have a high level of governance.

“The second development is already happening and that is the growth of multi-asset funds, that provide limited exposure to assets like commodities within a wider and well diversified portfolio. Fidelity has four such funds on its platform and we are already seeing trustee demand for them gathering,” adds Williams.

Skandia also doubts whether GPP schemes are embracing the individual funds – even though there is an increase in use among personal pensions.

But perhaps this is not a problem. Despite the low take-up of specific funds, perhaps many employees have adequate exposure anyhow. After all, the recent surge in natural resources stocks now means they make-up more than 35 per cent of the FTSE100 – around 16 per cent of the blue-chip benchmark is now invested in mining and basic resources companies, a whisker ahead of beleaguered banks.

“The FTSE does provide access to potential increases in natural resource values, particularly via the oil companies and miners. However, these constituents would rarely make up any more than around 30 per cent of a generalist UK Equity pension fund. Specialist funds investing in this area have performed much better over the last five years, with the ABI Commodity/Energy sector rising some 254 per cent over this period compared to only 89 per cent for the UK All Companies sector,” says Lee Smythe, a director at Killik.

Smythe says that for those wishing to access this area directly via their GPP or other DC pension plan, this would generally need to be done via a specialist external fund link [if available] as most insurers do not have specific commodity funds in their own internal fund range. Friends Provident is adding a commodity fund to its core GPP fund in response to demand from investors, however.

“Of the funds most likely to be available as external fund links under group pensions, I like Blackrock Gold andamp; General for exposure to precious metals, but for a more diverse holding I like JPM Natural Resources as this also has exposure to energy, other base metals [such as copper] and some soft commodities [such as wheat] in addition to gold and other precious metals,” he adds.

But Andrew Merricks at Skerritt Consultants in Brighton [who is another that worries that the commodity bubble could burst] disagrees. He believes in the long term story on commodities, but in a GPP or DB pension scheme it should be left to exposure through such vehicles as FTSE or managed funds, as sentiment can turn pretty quickly he says.

“The demand for commodities is supposedly going to be fuelled by demand from China, India et al, but what if the global economic downturn slows demand, or more likely, something unforeseen comes along to change the picture? With the speculative money flooding into vehicles such as exchange traded funds [and mine is among it] what will happen if this money starts to flow out again? A GPP scheme could easily hold too much to be necessarily liquid enough to get out quickly, and should we be speaking in such trading terms for pension money anyway?”

Merricks also argues that if the commodity bandwagon continues to roll, stocks such as Rio Tinto and Anglo American will rise up the FTSE ladder, benefiting passive equity investors. However, for those seeking more active exposure, the BlackRock World Mining Trust, the Ruffer Baker Steel Gold Fund, the Eclectica Agriculture Fund and the Investec Global Energy Fund will all hit the mark in their respective commodity sectors. “Mandamp;G Global Basics may play them all with a wider remit,” he adds.

Mark Dampier at Hargreaves Lansdown shares a similar view with Merricks and wonders whether people will be doubling up their exposure without realising. “The FTSE100 gives you about 16 per cent not counting oil which doubles it. It is quite possible to argue that investors might be in danger of repeating the same mistake as in dotcom time. Also exposure to Asia and emerging markets is also very linked to the commodity story so you need to be careful. I believe it’s a long story too but this hardly rules out some very sharp falls on the way.”

It is probably too soon for employers or employees to play the commodity game on their own. Sipp investors are getting in on the act, with many using structured products to get exposure to the asset class. “They do not have to worry about volatility and so are using plans offered by the likes of Meteor and Dawnay Quantum,” says Jason Walker at AWD Chase de Vere.

But you wonder whether employees are missing a trick. It is not surprising that Henderson reckons it is madness not to have any exposure at all to natural resources. “Having 30 per cent may be a bit much but certainly portfolios should have at least 15 per cent,” he adds.

Indeed, it is worth noting comments made in the Barclays Equity Gilt Study 2008 in which it analysed the natural resources phenomenon. They suggest it is a no-brainer. “From an investment perspective the outlook is reasonably clear, favouring a lasting secular rally in real natural resource prices. The current global slowdown will probably soften prices at some stage. However, unless one chooses to believe that the developing economies are willing to arrest their rising prosperity at prevailing levels, the long run trajectory for raw material and energy prices is firmly upward.”