Commodities provide new horizons

Hard to believe right now, but hedging against inflation might be the next big headache for investors, especially those who have been piling into bonds with apparent abandon.

The "free" money still being pumped into the global financial system is going to manifest itself in runaway inflation that will decimate bond portfolios as it did in the 1970s, warn commentators alternately dismissed as fear-mongers, or hailed as realists.

In the near-term it's not a problem at all, said Bank of America chief economist Mickey Levy last week of concerns that a record US deficit and huge new government spending would fuel inflation. "But it could be a very large long-run problem," he qualified.

And that is a signal for investors to start thinking now about strategies to hedge their portfolios in the same way that homeowners have been rushing to lock in lower three to five-year fixed mortgage rates.

Investing in commodities (real things like metals, oil, cotton, milk, sugar, cocoa and soy bean) is a classic inflation hedge. But their attraction is not just that commodity prices go up with inflation, says Tower fund manager Michael Coote. It's also the case that commodity prices tend to react differently to share and bond prices, and that provides investors with useful diversification, he says.

On the surface, events following the credit crunch in late 2007 proved that one wrong. As share prices spiralled down so too did commodity prices, which fell well below their 2007 highs. Investors rushed to sell whatever they had to reduce debt and stay alive, including commodities, usually a good protection against shocks in an unstable world.

But exceptional circumstances may now be playing into the hands of investors. Lower commodity prices represent a good buying opportunity, despite the fact that some prices have already climbed back significantly. And the longer term argument for investing in commodities in the aftermath of the recession remains, says Coote. Hundreds of billions of dollars poised to invest in energy projects, crude oil and extractive metals to meet rising demand was stopped dead in its tracks by the credit crunch.

"When we come out the other side of the recession, increased demand will meet a supply bottleneck and that will put upward pressure on commodity prices," said Coote. The rising price of oil will put pressure on substitute biofuel commodity prices (corn, soybeans and sugar), and rising standards of living in China and India will mean pressure on practically all commodity prices.

However, buying commodities in their own right apart from precious metals like gold and silver is not practical for private investors, unless they can store barrels of oil or stock extractive metals.

The other worry is the sometimes extreme volatility of commodity prices. However, just as commodity prices usually move differently to those of shares and bonds, they also move differently to each other.

So an investment opportunity made for a fund which invests in a range of commodities to counteract the volatility extremes of any one commodity, and which is able to invest either in an index which follows commodity prices, or which actively trades commodity futures' contracts.

When commodity prices started heading higher in the early 2000s, there were no locally based commodity funds. Now there are at least four, and what was a novelty for investors is starting to become mainstream. The NZ Super Fund holds a 5% allocation in commodities, and fund managers like Coote recommend at least that allocation in private investor portfolios.

Tower was early in the field with its Tower Global Commodity Fund in April 2006. The most recent is another Liontamer commodity fund which opened for new investors earlier this month, and which closes on October 16.

Beyond that is the possibility of a Swiss-based fund from Diapason Commodities Management which has been promoted and hosted in New Zealand by investment strategist Louis Boulanger.

Boulanger says after meeting with prospective clients in recent weeks, there is a long way to go here.

"European investors were allocating 3-5% of their portfolios to commodities five or six years ago when these funds gained popularity, but now many institutional funds are between 10-20% in commodities, and some private investors who know what they are doing are up to 25% in commodities," he says.

Previous commodity bull markets (1906-20, 1933-49 and 1968-82) each lasted at least 14 years, says Boulanger. "If history is any guide, this one will last some time until 2014 and 2022," he says.

The other significant commodities' players in New Zealand are experienced commodity trader Robert Holroyd's Sirius fund, launched last year, and the Pathfinder Asset Management's commodity fund, launched in April by Deutsche Bank veterans John Berry and Paul Brownsey, and backed by a board with heavyweight names Sandy Maier, and Catherine Savage, former managing director of AMP Capital Investors.

Some funds, like Tower's, are open-ended, so that investors can increase their portfolio allocation to commodities at any time, or sell out completely. Investors in Liontamer's fund will be virtually locking their money away for either five or six years.

Typically, investors' money is held in cash and fixed-term investments, while an equivalent amount is exposed to tracking a commodities index which reflects price rises and falls in a range of commodities.

But within the fine print of each investment statement are a variety of alternatives.

With Liontamer, for example, you can have your original capital guaranteed to be returned at the end of the investment period, and take 100% of the upside of any index movement, or take 130% of any upside, but also be exposed to copping any losses if they occur.

Both Sirius and Pathfinder are market-timing funds, and allow fund managers to take a 100% exposure to a commodity index via a futures contract or commodity-linked notes, or withdraw from the market and invest wholly in cash when commodity prices crash, as they did in 2008.

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