London, 7 June 2011: Reuters

Active management of commodity investments can help boost returns and provide diversification and is a better alternative to passive indices, consulting firm Mercer told Reuters. Active management refers to fund managers that buy and sell commodities on the basis of fundamentals, using their skills and expertise, while indices are a bet on higher prices.

A growing preference for active management is why the number of requests for searches -- selecting fund managers for new commodity pension fund mandates across Mercer's global client base -- rose to 20 last year.

That compares with six in 2009, said Simon Fox, a principal at Mercer. Figures for this year so far are not available. "Active management became more prominent with our clients last year. One of the reasons why it didn't become more prominent sooner was the 2008 financial crisis, which pushed commodity investments off the agenda," he said.

"Late 2009 and in 2010 people started to think again about their commodity allocation. If it hadn't been for the crisis we would have made the transition from passive to active sooner."

Many pension funds are still using commodity indices such as the Standard & Poor's GSCI for exposure. But these indices can be inefficient because they use futures contracts which have to be rolled over. When contracts approach maturity they have to be sold and new ones with a longer life have to be purchased, sometimes at higher prices.

INEFFICIENCIES

Few institutions have allocated to commodity fund managers. "There are inefficienies in commodity markets that can be captured through simple trading approaches if you can find managers with the right skills," Fox said.

Fox added the fundamentals of commodity markets were favourable and likely to remain so for years. The rise of Asia as an economic powerhouse, stronger demand from the region for all commodities is expected to keep the overall bull trend intact, even if there are periods of doubt when prices correct.

"Look back to global economic expansion at the end of the 19th century, at postwar reconstruction in 1945-1975. Those times saw big increases in commodity prices," Fox said.

"Today the driver is emerging markets and commodities are a part of that story." The diversification properties of commodities are strongest during periods of geopolitical insecurity, war, revolution, strikes and extreme weather. The impact of these events on financial assets such as equities are normally negative.

"There are good reasons why commodities can be a useful diversification in a broader portfolio," Fox said. Diversification is weakest during times of financial crisis when equities and commodities tend to move together. That has been the case since the third quarter of 2008 and can be seen in the high 60-day correlation -- mostly above 50 percent -- between the S&P GSCI index and Britain's benchmark equity index the FTSE 100 since then.

"The period around Black Monday in October 1987 and the Asian and Russian crises in 1997-1998 are previous examples of times when diversification benefits were weak," Fox said.

The best diversification investors can get is from spot prices, but that is difficult for pension funds as most do not have mandates that allow them to invest in physical markets.

"Spot commodity prices are a reflection of the immediate economic environment, equity prices look further into the future," Fox said.

Ends --

Reuters – for Commodities Now.