Jenny Lowe explains how increasing numbers of investors are participating in the commodity boom.

As the global financial crisis caused the prices of most asset classes to plummet, commodities have been gaining favour among investors. According to specialist exchange-traded commodity (ETC) provider ETF Securities, commodities were the best-performing major asset class in the first half of 2009, outperforming developed market equities, bonds and cash.

In fact, according to ETF Securities, commodities have been the best-performing major asset class over the past ten years.

Emerging demand
So why have the commodities markets been booming at a time when everything else is experiencing a bust? Well, many point to China, and other emerging markets, as the main driving force behind the surge in commodity prices.

As a result, many experts believe that we are at the start of a very prolonged commodities bull market, set to last for almost two decades. Steve Goodwin, an analyst at Hargreaves Lansdown, suggests, ‘For much of last year, investors worldwide were concerned about the impact that a recession would have on the demand for energy and base metals.

‘The fortunes of the commodities market are linked to global industrial output, and more production means more demand for natural resources. We believe that the long-term drivers of what some are calling the “commodities super-cycle” remain fundamentally unchanged despite the credit crunch.’

Fundamental drivers
Jonathan Blake, manager of the Barings Global Agriculture Fund, argues, ‘In very broad terms, I think the key drivers of the resurgence in commodity prices, from the beginning of this decade, have really been caused by an industrialisation of emerging markets. People can look at the emergence of China as one explanation. It is a process that comes as a part of the economic development.’

Emerging markets have a wealth of natural resources, including more than 90 per cent of oil and gas reserves, 70 per cent of coal reserves and 60 per cent of copper, nickel, iron ore and bauxite reserves. ‘South-south trade’ (i.e. trade not involving developed economies) has proved resilient and emerging markets are fast becoming the largest commodity consumers as the urbanisation process continues.

Furthermore, emerging economies are less indebted than their developed peers at the country, company and individual level. Importantly, banks in emerging market countries have emerged from the recent credit crisis relatively unscathed, as they generally had little or no exposure to the ‘toxic assets’ associated with the sub-prime mortgage fallout in the US.

China is the key
‘China is very strong fiscally, with a budget surplus running at 1.2 per cent of GDP. This means that the government is well placed to deliver supplementary stimulative measures if required at a later date,’ argues Gigi Chan, manager of the Threadneedle China Opportunities Fund.

‘The country also boasts a healthy banking system, with robust balance sheets that have minimal exposure to sub-prime assets. Unlike leading Western economies, China has not had to undergo the process of corporate and private de-leveraging. As a result, there is an abundance of liquidity, and we have already seen an aggressive pick-up in bank lending this year.’

Continued demand
This liquidity is finding its way into the global commodity markets. Despite experiencing a sharp decline towards the end of 2008, commodity price movements so far in 2009 have been upwards again, signalling that investors should be investing over the long term to benefit from this sector.

Marius Botha, deputy manager of the Threadneedle Commodities Crescendo Hedge Fund, points out, ‘Although the economic growth rate of these emerging market countries has slowed, it is by no means over. The current global downturn has merely slowed growth and their increasing demand for commodities will certainly return.
‘In fact, there have been a number of economic indicators that suggest ‘green shoots’ are already starting to emerge in China.’

He adds, ‘Investors who want to invest in commodities now should invest in essential hard assets through actively managed long-only funds or commodity hedge funds. Anybody investing in commodity-related stocks and shares themselves should make sure they understand the fundamentals of each commodity and exercise more investment discrimination if they are looking to outperform commodity indices.’

But which commodity?
Commodities can be broken down into four basic categories: precious metals, base metals, energy and agricultural products (also known as ‘soft’ commodities). Of these, precious metals – dominated by gold – looks perhaps the most attractive this year, says Nicholas Brooks, head of research and investment strategy at ETF Securities.

He points out that gold made money for investors in the turbulent months of 2008 and could do the same this year. He says, ‘Uncertainty is likely to remain high over the next year, and in such times people turn to safe havens, with gold being the ultimate one. A further plus point is that gold is priced in dollars, so sterling investors would benefit from any continued strength of the dollar against the pound. The same currency factor applies to investing in oil.’

Agricultural commodities fell in price last year, but they still performed better than most stock markets. Thomas Becket, head of global investment strategy at PSigma, believes there is a likelihood that extreme weather conditions will recur in various parts of the world this year, leading to poor harvests, which will push up the prices of ‘soft’ commodities. Among those that could rise sharply are wheat and corn.

Barings’ Jonathan Blake adds, ‘The world’s population is increasing, diets are changing as people become wealthier and the growth in biofuels, which diverts foodstuffs to fuel, is continuing. We call this the Three F’s – food, feed and fuel.’

Sticking with shares
However, Gertjan van der Geer, manager of the recently launched Pictet Agriculture Fund, thinks that agriculture stocks will produce better returns than any future increase in the price of soft commodities. ‘We expect less correlation between equities and food prices over the coming years, and equities are better placed as they have the possibility to benefit from consolidation,’ he says.

Van de Geer adds, ‘Agricultural demand is set to double in the next 40 years, particularly as the world population grows and incomes increase in emerging markets, making a case for investment in order to keep food prices affordable and reduce waste.’

However, a key attraction of direct investment in commodities is that their performance is not closely correlated with other asset classes, particularly shares, so they can do well when many other forms of investment are doing badly, and for those investors that believe inflation will rear its ugly head in the coming years, commodities offer something of a safe haven.

How to invest
When it comes to what type of product to use in order to gain exposure to commodities, it really depends on whether you subscribe to the long-term argument for rising prices, or simply see this as the latest in a string of rallies.

Exchange-traded funds (ETFs) are a cheap and flexible way to gain exposure to the commodity sector, and due to rising demand there are now a large number of different products available to investors. These products simply replicate the rise and fall of a particular commodity index or basket of commodities.

For the bolder investor, ETF Securities has more than 100 individual commodity ETFs, marketed as exchange-traded commodities (ETCs), covering everything from coffee and wheat to gold and natural gas. To provide additional flexibility it has also launched some ‘short’ ETFs, which allow investors to make money when commodity prices are falling – ideal for those who think the commodity horse has already bolted.

‘ETFs are cheap, easy to use and liquid. You have more and more choice now and you can get exposure to a great range of commodities,’ argues Thomas Becket. ‘But at the same time, given the polarisation that we are seeing in the commodities markets, you could benefit from having an active manager.’

The equity route
‘An investment in a diversified commodity index has provided equity-like returns but with a low correlation to most equity indices,’ points out Mike McGlone, director of commodity indexing for Standard & Poor’s Index Services. ‘The more traditional portfolio mix of stocks, bonds and cash has been migrating towards stocks, bonds, cash and alternative assets, such as commodities. Allocating a portion of a portfolio to commodities has generally provided good returns, but with lower overall volatility.’

Another option would be to invest in a unit trust or investment trust that invests in shares associated with certain commodities. Shauna Bevan, investment manager at Charles Stanley, says she prefers more traditional mutual funds over ETFs when it comes to gaining exposure to hard commodities.

For example, she favours the Investec Enhanced Natural Resources Fund, which is run using full UCITS III powers that enable it to take both long and short positions in the portfolio. This has the potential to protect investors against downside market movements as well as to take advantage of the upside, increasing the potential for a better risk/return balance.

However, Bevan does accept that there are potential drawbacks to getting exposure to commodities through a portfolio of listed shares. Taking an example from one of the best-performing funds of recent years, she points out that ‘The JPMorgan Natural Resources fund invests in the shares of companies that are engaged in the production and marketing of commodities worldwide. The fund is overweight in gold and precious metals, and the problem with investing in a fund made up predominantly of mining stocks is that over the short to medium term you, you still own an equity and get the plays of equity markets.’