think-outside-the-box

Canada has long been a nation of hewers of wood and, more recently, drillers of oil.

Investors have generally followed that axiom, rarely straying from the commodities they see coming out of Canadian soil.

This home bias has led to significant cash placements in oil, gas, timber and gold, based on strong returns and a quest for investments offering returns not correlated to stock markets.

But since commodity shares dominate the S&P/TSX Composite, it may be time to question whether commodity investments on home turf satisfy the diversification desire.

“The reason to look at different commodities is broader diversification,” says John Stephenson, senior vice president and portfolio manager at First Asset Investment Management Inc. in Toronto, and author of The Little Book of Commodity Investing.

“If you buy rubber, you’re getting exposure to Thailand, Malaysia, and other places,” he says. “If you stick with gold you’re really exposed to Canada because a third of the world’s gold is mined by Canadian companies.”

A desire for more pronounced negative correlation to stock and bond markets led Matthew Phillips, portfolio manager and director, wealth management at Richardson GMP in Guelph, Ont., to turn to a managed futures fund that includes significant investments in soft commodities like coffee and cocoa. “I look at them as an entirely separate asset class alongside stocks and bonds,” says Phillips, who has been using managed futures for about two years.

How to do it

Transitioning into non-mainstream commodities should be slow, and well communicated to clients. “It’s not a tough conversation, but it’s perhaps a longer one,” Phillips says.

He makes extra effort to communicate the commodities’ demonstrated ability to protect the rest of the portfolio from volatility (see “Commodity investing cheat sheet,” this page).

“As of the end of May 2012, the managed futures fund was moving up when markets spent the previous three months selling off [and prices were in decline], which made it very easy to communicate to clients why it’s such a useful element in their portfolios,” he adds.

In terms of portfolio construction, your clients’ exposures to commodities should be closely tied to their risk profiles.

In Phillips’ target allocation model, alternative investments, consisting partially of managed futures, sit alongside cash, fixed income, Canadian equity and foreign content. They’re a class present in every portfolio.

To determine the level of exposure to each, he numbers his five portfolio profiles on a sliding scale of risk tolerance, with one being the most conservative and five being the least.

For alternative investments, he allocates a percentage that is double the model number.

“The most conservative profile has 2% exposure to alternative investments and the most aggressive has 10%,” Phillips says.

This approach lets clients test-drive commodities that can be very volatile, in part due to their limited liquidity.

“You might start with 1% of your portfolio with a goal of moving up to 5% or 10% in a managed futures approach to investing in commodities,” says Roland Austrup, chief executive officer and chief investment officer of Integrated Managed Futures Corp.

The ability of managed futures to go both long and short on commodities is among their key attractions. But ETFs remain the most popular point of access, allowing you to look for greater exposure to non-mainstream commodities.

But the Canadian market doesn’t yet have single-commodity ETFs for soybeans, cotton, coffee and cocoa like in the U.S. and UK.

And Yves Rebetez, managing director of ETFinsight, says the Canadian market is unlikely to support any additional single-commodity offerings soon.

“Providers have moved away from offering direct exposure to single commodities, opting instead to provide a better-thought-out instrument for diversified exposure,” he says, adding that may not be a bad thing.

Also worth considering are peripheral equities that can capture commodity price gains.

“In situations where grain prices have bottomed out, I’ve made some good money by investing in fertilizer stocks, agricultural machinery and seed stocks,” says Jonathan Baird, CFA and vice-president, investments at NexGen Financial L.P., where he manages the NexGen Global Resource Funds.

“These companies can capture gains in a range of agriculture commodities such as grain and soybeans. And these stocks offer the most effective means to participate in strength in the agriculture commodities for a Canadian mutual fund manager, as regulations prevent mutual funds from investing directly in commodities.”