Pension Funds and Commodities

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Includes: DBC, OIL
by: Sandeep Daga

Funds and fundamentals seem to have reached a compromise by dividing the year in two halves. Funds drive the first while fundamentals catch up in the next. The pattern seems to be repeating this year, leaving investors and hedgers confused once again.

It wasn’t long ago that pension funds opened their wallet for commodity markets. A long trend of the falling dollar, inflation-hedging and the need for portfolio diversification were some of the reasons used by the investment managers for getting pension money for commodities. Pension funds, who had their hands full with Treasuries, real estate, equities, corporate and mortgage bonds, were quite willing to step-up.

The investments were made in several ways. Initially, backwardation in some commodities gave attractive roll-over yields thus making passive investment into long-only commodity indices an attractive idea. However, as the place got over-crowded, the roll-over yield turned negative.

Several investment managers then brought in structured notes and baskets of chosen commodities. Some pension funds sought help of hedge fund managers. In addition to CalPERS’ decision to invest 1-2% of their portfolio into commodities, the year 2006-07 saw several other headlines of new pension monies and creative ideas of investing in commodities. Exchange volumes soared and so did the volatility.

An entirely new breed of long-term investor was changing the landscape of commodities. More money meant higher prices which, in turn, helped getting happy investing experiences for these funds and those sitting on the fences had no reason to doubt the ideas shown by their investment managers. Momentum kept picking up gradually.

Estimates suggest that fund investments into commodities increased from $80 bln in December 2006 to $110 bln in December 2007. This was against a typical rise of $6-8bln per year in the earlier years. In the first half of 2008 another $40-50 bln got into commodities. Too much money was chasing a relatively smaller market and taking it far away from its “real” economics. Fundamental had to catch-up, timing was unknown.

Several things have changed post credit crisis; but several others haven’t. Pension funds continue to be interested into commodities. Polls in some of the investor conferences suggest that pension funds have realized a good relative return in commodities and would seek to increase their investment in this class at the cost of equities.

The size of pension funds globally is about $15 trl. About 2/3 of this is in the western economies; a place where investment restrictions are less and asset-liability mismatch quite high. The credit crisis has further deepened the deficit in their balance-sheet at a time when a large proportion of their population is reaching retirement. The funds are desperate for returns. Even 1% of their total portfolio earmarked for commodities could create big waves.

Commodities have established themselves as a distinct asset class; investible money is natural to come by. However, we can’t ignore size of this market relative to flows of new money. Regulators seem to be rising to the occasion. The new Chairman of CFTC, US regulator, would decide whether federal speculative limits should be set on “all commodities of finite supply”, in particular oil, natural gas and energy commodities.

The CFTC will hold hearings in July and August. Currently, CFTC sets position limits for some agricultural products, but not energy markets. While analysts feel that direct and indirect restrictions could reduce speculation in these markets, the flow of investment money into commodities can’t be reversed anytime soon. Nevertheless, the hedging community, who are seeking lower volatility, will keep an eye on Washington and another on “New York” for further developments.

Disclosure: No Positions