After several years of poor performance investors are warming to commodities.
Helped by the return of volatility, strong returns and declining correlations with other asset classes, money has started to trickle back into the sector.
After a record $50bn of net redemptions in 2013, total inflows into passive index tracking and commodity-linked exchange traded funds this year have so far totalled just over $6bn, according to research by Citigroup. Agriculture, energy and bullion funds have led the way.
“It’s time to again take commodities seriously as a portfolio diversifier for all the reasons commodities rose as a substantial part of investor portfolios during the first half of the last decade,” the bank said in a recent report.
Attracted by rising prices, China’s seemingly insatiable appetite for raw materials and low correlation to other sectors, investors piled into commodities during the boom years before 2008.
In recent years, however, the sector has been shunned by large investors as Wall Street analysts, big picture strategists and powerful consultants turned cold on oil, metals and grains amid lacklustre demand for raw materials. Retail and institutional commodity assets under management have fallen from $525bn in April 2011 to about $350bn today.
But sentiment has started to improve following a strong start to the year on commodity markets where the Dow Jones UBS commodity index had outperformed the S&P 500 by more than 8 percentage points.
“It’s got commodities back on the radar screens of investors,” says Kevin Norrish, head of commodities research at Barclays.
He said one of the main reasons investors are looking at commodities again is declining correlation with other asset classes. Investors are also becoming concerned about their exposure to equities and bonds and looking to place contrarian bets.
During and after the global financial crisis commodities moved in lock-step with equities, bonds and the US dollar as financial markets were in the grip of “risk-on, risk-off” trading. That upset many investors because commodities were supposed to provide diversification from bonds and equities. But many analysts believe the events which drove the tight cross correlation are starting to fade.
“Commodities like any liquid asset saw a big increase in correlation during the financial crisis. But that was merely off the back of people needing to get cash in a hurry,” says Jason Lejonvarn of fund management group Hermes. “Correlation numbers are now well within the historic norms of the last 20 years.”
Since the beginning of the year the 90-day rolling correlation of the Dow Jones UBS commodity index and US equities has been consistently negative.
The decline in correlation is important, say analysts, because it is helping fundamentals reassert themselves and means supply and demand balances are determining the winners and losers in commodities once again.
“Volatility makes it easier to pick winners and losers,” says Mr Lejonvarn. “There’s four or five commodities that are double digit gainers in the year to date.” These include nickel and Arabica coffee, which has almost doubled this year due to damage caused by an unprecedented drought in Brazil.
Returns from commodity investing are also improving because of a broad “backwardation” in futures markets – when prices for the new contracts are lower.
The structure of the forward curve is a critical component of returns for investors. When commodity contracts mature each month, fund managers usually sell and then buy back the next month’s contract to replace them, so when futures markets are in backwardation, selling high and buying low boosts returns.
However, when the new contracts are more expensive, or in a “contango”, the rollover leads to losses as investors are selling low and buying high.
According to analysis by Hermes, between 1970 and 2013 the roll yield produced negative returns of 0.71 per cent a year. However, in 2013, roll yields delivered a return of 1.5 per cent while the current price structure in Brent oil implies a return of 5 per cent from the roll yield over the next year. Soyabeans, which are in record backwardation, are offering returns of 20 per cent.
The combined roll returns and the “spot return” or the gains on prices year-to-date, is 4 per cent, the highest in four years, according to Hermes.
But for all the positives, many investors remain wary of investing in commodities. One reason is slowing economic growth in China, which accounts for about 40 per cent of global commodities demand.
“Commodities are a difficult asset class. It’s not like bonds and equity – there are no dividends and coupons,” says Guy Wolf, head of market analytics at brokerage Marex Spectron.
And not everyone is convinced the big move up in commodity indices can be maintained or that correlation will remain low, especially if a lot of investor money flows back into the sector. “Why are commodities uncorrelated now? Probably because there is not a lot of financial money in there”, says Mr Wolf.
Yet for all that, the outlook for commodities is much brighter than it has been for several years.
Says Mr Norrish: “For several years investors were paying to be in an asset class that offered no diversification and poor returns, now they are getting a positive carry, diversification and decent returns.”