Commodities have been the investment success story of the past five years. As equity markets become more volatile and property loses its lustre, investors are becoming increasingly aware of the returns to be made from a wide range of physical commodities.

But just how easy is it to get an exposure to the commodity markets? How much risk is involved? And, most significantly, given the dramatic recent outperformance of the sector – with many commodities seeing their prices hit record highs – can these returns be sustained in the future?

Hitting the heights
The reason why growing numbers of investors are taking an interest in the commodity markets is that commodities have been outperforming other asset classes. Table 1 (taken from the most recent Clerical Medical Assetwatch survey), comparing returns for a range of different asset classes, shows that in 2007 commodities were, on average, well ahead of the competition.

Martin Ellis, chief economist at Clerical Medical’s parent group, HBOS, argues that ‘Recent market performance highlights the benefits of portfolio diversification. In 2007, commodities were the best-performing asset class. Given the recent financial market turmoil, UK and international shares provided subdued returns in 2007, while UK residential property continued to be one of the best performers.’

He adds, ‘Precious metals as a specific category of commodities have performed very strongly over the past year. Gold is viewed as a store of value and a hedge against financial market uncertainty and inflation, which has helped to boost its price to record levels.’

However, it is significant that Ellis talks about commodity investments being a good diversifier within a wider portfolio, since most investors will only be able to tolerate a limited exposure to these investments. Mark Mathias, chief executive of Dawnay Day Quantum, which specialises in constructing commodity-based investments, observes, ‘Depending on what methodology you use, academics would suggest that you should have between nine and 12 per cent of your total portfolio in commodities.’

However, he also points out, ‘The interesting thing is that institutional investors are still massively underweight in this area. Many don’t have any exposure to commodities at all. So the retail investors who get in now are getting in ahead of the pack, not just in terms of the weight of money going into commodities, but also in terms of being in at
an early part of the cycle.’

A volatile mix
The reason that commodities need to be handled with care within an investment portfolio is pretty obvious. Table 2 (also taken from the Clerical Medical Assetwatch report) demonstrates that this level of performance has been going on for some time, with the ten-year returns for several commodities in excess of 300 per cent. However, this performance is not uniform across all commodities – some, particularly some of the agricultural, or ‘soft’, commodities, have actually shown negative returns over the past decade.

This is an indication that commodity prices are extremely volatile. Mark Mathias puts it bluntly: ‘There is going to be volatility in the markets because we are talking about the most volatile asset class there is. But if you take the long-term view, then you can ride out that volatility.’

Ashok Shah, chief investment officer at London & Capital group, agrees that ‘Investors also have to realise that commodities are very volatile. It is not unusual to see their prices fall by ten to 15 per cent in a week, but they can also rise by a similar amount. Commodities are a good diversifier overall as they operate on different cycles, but they are very volatile, which makes them difficult to trade. So you ought to think very carefully before you try to be too clever about trading these things.’

But he adds, ‘Having said that, there has been a spectacular rise in most commodity prices over the past five years. However, you must remember that prior to this period, interest rates were very low and there was a lot of liquidity in the system, after the world’s monetary authorities reacted to the fallout from the TMT bubble. What you got, as a result of this increase in liquidity, was a global boom. It happened first in the developed world, but then the emerging economies also picked up on the back of their exports to the developed economies, and that is what has driven the rise in commodity prices.’

Looking for the super-cycle
Most investors will be familiar with the idea that markets move in cycles, but the perceived wisdom in the commodity arena is that it is subject to ‘super-cycles’ where prices can continue moving upwards for a decade or more.

Mark Mathias is certainly an enthusiast for the super-cycle theory. ‘The way we see it, general commodity cycles are very long. Commodity guru Jim Rogers has pointed out that they typically last anywhere between 15 and 23 years and so you have to ask yourself why you think it will be different this time, and I have to say that I don’t think it will be.

‘I think that what we have seen over the past three or four months is a lot of froth coming off of the market. If you think of the four main sub-sectors of the commodity market, only one has really suffered and that is industrial metals, which have come off a bit. But several soft commodities have reached record highs, and gold and oil prices are still very strong.’

Mathias points out that ‘The key trend is the massive demand from China, India and the whole of the rest of the emerging market universe. Twenty years ago, US demand was what drove commodity markets and, although US growth is still important, it is now emerging-market demand, and especially demand from China and India, that drives growth in the commodity markets.’

He argues that ‘As a result, any slowdown in the US is only going to have a marginal effect on commodity growth. And even if Chinese growth slows – from its peak at over 11 per cent to, say, eight per cent – that is still going to represent an awful lot of demand.’

Felix Wintle, manager of the Neptune US Opportunities fund, agrees that ‘Looking at commodities in general, I think we are in a super-cycle over the long term. The current cycle started around 2003 so it is still quite young. It is being caused by a demand push, particularly from China. It really is China that takes up the lion’s share of demand.’

However, Ashok Shah is more cautious. ‘The minute you begin to talk of super-cycles, you are on a hiding to nothing. The first thing you must do is to ask why commodities have been so strong. What we have seen, if you look at the main sub-sectors of the commodity space, is that there are specific drivers for each of them but also some similarities.’

Understanding the markets
It is, therefore, important to understand that the commodity space covers a number of different markets, each with their own distinctive characteristics. Ashok Shah explains that ‘There are four main sub-sectors into which you can divide the commodity markets – energy, base or industrial metals, precious metals and agricultural commodities (or “softs”).’

Felix Wintle adds that ‘Commodities do tend to move as a group, but with individual commodities particularly active at any given time. For example, copper was the key commodity, in terms of price movement, a couple of years ago, largely on the back of Chinese demand.’

He observes, ‘Each commodity has its own idiosyncracies. With gold, for example, there is an awful lot of it about above ground, which means you don’t have to go mining for it. It is seen as a store of value and almost as a reserve currency alternative to the dollar, but you also have the jewellery market, which is a very important market for gold.’

Wintle adds, ‘Then you have platinum and palladium, and although they have their industrial uses (for example in catalytic converters), there is a real rarity value with these metals as well. So if you get interruptions in supply, as happened recently
in South Africa, then prices can rise dramatically. The scarcity means that these metals are very price sensitive.’

Ashok Shah says, ‘With precious metals, gold is simply being treated as an alternative currency at this point, and you have to ask whether it can continue to do this. The drivers are still in place, but you have to question how much more upside there actually is.’

He also explains that ‘With things like oil and gas, you have a very tight demand and supply equation. So a slight increase in demand pushes prices up, while producers have been very good at ensuring that they don’t increase the supply too much. So the boom in energy prices was because of a strong global growth rate and an increase in consumption.’

Shah adds, ‘Something similar happened with base metals. You have seen very poor returns on capital in this sector over many years, so there was very little investment in new capacity. Then you saw increased demand from the developing economies, which squeezed out any excess capacity in the system, and that is why you have seen base metal prices rise.

‘Also, with the growing importance of environmental concerns and government regulation, the lead time to bring new production on stream is much longer these days. Eventually, new supplies of these metals will appear, but prices will be very volatile in the meantime.’

The rise of soft commodities
Felix Wintle explains that ‘Soft commodities are in a very long-term trend. Demand for softs is predicated on GDP growth and rising incomes, and these conditions are particularly prevalent in emerging economies. As people become more prosperous, they move from a starch-based diet, bread and rice, to a protein-based diet, with a lot more meat, and this is the situation in emerging economies.’

Ashok Shah feels that ‘With soft commodities, the big influence has been the growth
in demand from the emerging markets. As your GDP increases, the first thing you do as a population is consume more food, and food of a higher quality. Meat consumption in these emerging economies is rising fast, and it takes 5kg of grain to produce 1kg of meat.’

Mark Mathias adds that ‘You also have the constraints of energy supply. The fact that energy is in short supply means that there is a premium for this sort of development, and the efforts of the green lobby mean that governments are forcing conversion of fuel from agricultural products at an unnatural rate, which is going to continue to increase the demand for agricultural commodities.’

Ana Cukic-Munro, co-head of the Multi-Asset Group at Insight investments, the investment arm of the HBOS group, says that there are two main themes that her team are currently looking to follow in the commodity markets – livestock among the soft commodities and platinum among the precious metals.

‘Livestock is an extension of the agricultural commodities theme. It is a downstream commodity to grains, and grains have rallied massively. In the short run, with higher costs, farmers tend to slaughter more animals, thus depressing spot and reducing inventories. As grains prices remain high, the farmers are forced to pass on the higher input prices.’

She adds, ‘Historically, a 100 per cent increase in grains should lead to a 30 per cent-plus increase in livestock, with a three to six month lag. The current increase in grains is not due to a supply disruption and we expect you could see livestock rise by the full 100 per cent in the coming year.’

Turning her attention to precious metals, Cukic-Munro points out that ‘Platinum is required to produce automobiles, trucks and diesel engines. It is impossible to produce catalytic converters required by environmental laws without platinum. It works as a catalyst, which means it helps promote a chemical reaction, breaking down pollutants without itself being consumed in the process.’

She adds, ‘There is also increasing demand for jewellery from rising affluence in Asia. The interesting thing here is that 80 per cent of the world’s platinum is produced in South Africa, but South Africa is running out of power and faces at least five years of power rationing. As a result, platinum prices could rise to US$2,000 per ounce.’

How to go about it?
So how do private investors get access to the commodity markets? Very few will want to trade physical commodities for a number of practical reasons, but the range of other options is somewhat limited.

There are essentially three ways to get commodity exposure – through some form of investment fund (which may hold the underlying commodities directly but is more likely to invest in the shares of companies involved in one or more of the commodity sub-sectors); some form of structured product (an investment note designed to run for a fixed period and generate a return based on one or more of the commodity indices); or an exchange-traded fund (which can be linked to a specific commodity index but, increasingly, ETFs are available that are linked to physical commodities as well).

The pioneer of commodity-based ETFs in the UK is ETF Securities, which has devised a series of what it describes as exchange-traded commodities (ETCs). Hector McNeil, head of sales at ETF Securities, explains that ‘ETCs are pretty much the same as ETFs. They are a market access tool that gives investors access to the commodity markets at wholesale cost and in a transparent and liquid form.

‘The irony is that while the commodity markets are the oldest markets in the world, they are the latest to be accessed by private investors, because investors don’t want to hold
the physical commodity.’

He draws an important distinction between ETCs and other ‘alternative’ asset classes. ‘Whereas, for example, property funds are suffering redemptions and having liquidity problems at the moment, and hedge funds take three months to redeem and are very expensive, with an ETC, you can buy and sell within minutes, and that is a very liquid form in which to get market exposure. We find that fund managers are using them a lot.’

He adds, ‘Grains and other agricultural commodities have proved very popular, because there are limited ways of getting exposure to these things. Investing via equities has its drawbacks, as they will be affected by market sentiment, rather than just reflecting the underlying commodity.’

Investors who prefer the investment fund route should also be aware that they are not simply restricted to funds with a specific commodity focus.

Felix Wintle, who runs a general North American portfolio, argues, ‘I would say that you can access these things best through the US, as you have a lot of listed companies there at all stages of the process. ‘For example, in the US, you have fertilizer companies, agricultural equipment companies and so on, and these types of company are seeing boom time at the moment.’