The role of commodities in Ucits multi-management portfolios
Including commodities in Ucits funds can bring diversification benefits and add alpha, but the higher costs associated with new regulations may prompt investors to search for other routes into the asset class
Some might argue commodities are not an asset class as they often have no yield in traditional terms, as is the case with equities and bonds. Regardless, we believe commodities have several interesting characteristics from a portfolio management perspective.
• Diversification benefits – Low correlation to equities and bonds
• Inflation protection – Commodity prices are directly and indirectly linked to inflation
• Alpha opportunities – High price dispersion as well as more complex opportunities and embedded risk compared to traditional asset classes. And because it is complex, skill is required. Whenever skill is required there is room for manager selection.
Commodities in UCITS funds
The breakthrough for allocation to commodities in Europe came with the introduction of Ucits III in 2001, which allowed cross-border Ucits commodity funds to develop.
Whether an investment portfolio should contain commodities or not is predominantly a question of investment philosophy. In a portfolio construction framework based on mean variance assumptions, a rational long-term investor would appreciate the diversification benefits and inflation protection they offer.
Consequently our opinion is that commodities should have a strategic allocation for diversification purposes. We favour the view that a large proportion of the world’s population will increase their standard of living quicker than the pace we currently find and will be able to explore new commodities. Finally, we also believe selecting the right commodity fund can add meaningful alpha.
Our long-term data analysis (100 years) concludes that a strategic allocation to commodities of up to 15 per cent is appropriate depending on the targeted risk. However, we think this quantitative starting point is a bit too aggressive. Considering the risks of owning an asset class that pays no dividends we suggest strategic allocations of up to 10 per cent depending on risk and return objectives. Taking a more short-term perspective our view is even more defensive, as we do not see commodities adding much to a portfolio from either a risk nor performance perspective. Our rationale is linked to our expectation that the current growth cycle is not sufficiently driven by infrastructure investments.
Manager selection
In our opinion there are two types of commodity managers.
The first specialises in trading futures and adds value predominantly by selecting the right futures contracts. Managers with this focus have been successful for a number of years partly due to fairly stable futures curves in contango, which has allowed the managers to systematically choose contracts with longer expiry than the benchmark. When selecting this kind of manager we look for highly specialised and skilled managers with proven ability to understand market dynamics and particularly futures curves. We need to be certain that the manager is also prepared for a curve with less stability and in backwardation.
The other type of manager focuses on selecting the right commodities or the right sector of commodities. This offers tremendous opportunities due to dispersion but also tracking error risks. It requires a different approach and the manager needs to understand the dynamics of the market drivers in a broader context. This includes macro-economic impact on prices, weather, long and short-term social trends and technology developments.
Judging the manager’s ability to identify these factors will be the key to success when selecting this type of manager.
Regardless of which manager one prefers, they all face a major challenge in Europe. With the implementation of the ESMA guidelines by the end of 2013, the possibility to trade unlisted instruments on single commodities was banned in Ucits funds.
The consequence is that trading costs and credit risks on investment banks issuing certificates which the funds now hold have increased. This might be the beginning of the end of active Ucits funds in the commodity space, which in our opinion is a shame. Short-term, this is less of a concern for us as we currently do not have a strong outlook for the asset class. It might be that regulation moves quicker than our market expectations. If not, we will probably consider index alternatives to gain exposure when it is time to re-enter the commodity market.
Peter Branner, global CIO and Mårten Gabrielsson, head of multi management, at SEB Investment Management
