Redefining commodities – there’s a commodity universe beyond gold and platinum

The years following the global financial crisis have been characterised by low returns in a low interest rate environment. Under these conditions asset managers – particularly in the fixed interest space – have had to consider alternative opportunities

Arthur Kamp, Economist at Sanlam Investment Management (SIM) says that commodities are difficult to predict and even more difficult to define. He was leading a panel discussion on Commodities & Currency at the 4th Annual African Cup of Investment Management conference ( http://bit.ly/u34ZLJ ) held in Cape Town on 29 August 2013.

The layperson associates the word ‘commodity’ with precious metals such as gold and platinum. In reality this asset class covers a wide range of tradable goods that give investors access to the weather (through agricultural commodities such as maize, soya and sunflowers); to politics (through oil) and business cycles (coal).

Defining commodities as an investable asset class is very difficult as there is no market cap weighted index as a starting point. Evan Gilbert, Head of Asset Consulting at MitonOptimal SA, points out that although institutional investors can choose from a range of diversified ‘commodity’ baskets little progress has been made in nailing down how best to invest in commodities.

“One solution to this problem is to create a better proxy for commodities by looking at the performance of the asset class in relation to the needs of South African savers,” says Gilbert. He adds that the three main reasons investors and asset managers buy commodities are for diversification, enhancing returns and as a hedge against inflation.

While diversification is a familiar concept to asset managers, the layperson will best understand it in terms of the saying, ‘do not put all your eggs in one basket’. In simple terms an investor wants to spread his capital across as great a cross section of the economy as possible. “The broad church of commodities gives access to weather, politics and business cycles – way beyond what is on offer from any asset class,” says Gilbert.

Can the ‘right’ basket of commodities really provide market beating returns over time? Arthur Kamp expressed concerns that the past decade of outperformance from the commodities sector was merely a blip in what economists believe is a long term real decline in commodity prices.

It is difficult to address this concern given the cross sectional volatility within the asset class except to say that enhanced returns are possible but not guaranteed. Likewise, commodities will only offer an inflation hedge if the basket is correctly constructed.

South Africa has only one investible commodity bundle at present. Standard Bank’s African Commodities Production Index is a diversified bundle of commodities weighted on actual commodity productions across the African continent.

But Gilbert does not believe that this solution is appropriate for his clients, ordinary members of pension funds. “You need to understand what exposure your members have to commodity prices and what impact commodity prices will have on their consumption behaviour,” he says.

Evidence suggests that commodities, particularly food, energy and transport prices, have a significant impact on the budgets of consumers, increasing in importance for the low income quintile. A carefully chosen commodity basket could therefore be a proxy for as much as 65% of a fund member’s consumption.

The result of these deliberations is a commodity basket with a difference. The MOCCI includes a food basket (maize, wheat, sunflower and sorghum), an electricity basket (coal) and a transport basket (oil).

“In structuring this basket a conscious decision was taken to exclude precious and base metals in favour of more sensible commodities,” concludes Gilbert. The index has outperformed equities, gold and various production-based indices over a number of time frames.

It is difficult to predict the next 10 years and there are different forces at work in each segment of the above-mentioned basket. The panel confirmed that commodity returns would always be volatile and for this reason it was important for investors to be properly diversified across asset classes, including commodities.