Think outside the commodities 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.

5 less-mainstream commodities

• Palladium and platinum: Both metals are expected to benefit from rising demand for automobiles in China, with palladium used in catalytic convertors for diesel engines and platinum in catalytic convertors for gasoline engines.

  How to access it: ETFS Physical Palladium, ETFS Physical Platinum, iPath Dow Jones-UBS Platinum Subindex Total Return ETN.

• Cocoa: Consumption is rising, led by demand in emerging markets. In a recent report, Citi predicted steady growth in cocoa prices through 2012 and 2013.

  How to access it: The iPath Dow Jones-UBS Cocoa Subindex Total ReturnSM ETN is one option. Also, in equities, Nestlé stock offers exposure to cocoa.

• Lean hogs: Lean hog futures hit an eight-month low in early May, prompting views that prices had hit bottom amid rising demand and sliding slaughter numbers.

  How to access it: ETFS Lean Hogs offers direct exposure, while the iPath Dow Jones-UBS Livestock Subindex Total Return ETN offers futures-based exposure focused primarily on lean hogs and live cattle. In equities, Smithfield Foods and Tyson offer exposure to lean hog prices.

• Aluminum: Demand is rising and European inventories are bottle-necked, prompting Citi to predict prices to return to peak levels by the end of 2012 and set new highs in 2013.

  How to access it: ETFS Aluminum offers direct exposure by tracking the aluminum futures contract traded on the London Metals Exchange (LME), as does the iPath Dow-Jones Aluminum ETN. Also: Alcoa offers aluminum exposure in equities.

• Tin: Robust demand has put a premium on retail prices, even though futures prices fell to the $US19,000 per tonne range in the second quarter of 2012. But with strong consumer demand and as the most supply-constrained of all base metals, one BNP Paribas analyst forecast tin prices hitting at least $US25,000 in the second half of 2012 and surpassing $US27,000 per tonne in the first half of 2013.

  How to access it: Barclays offers an iPath Dow Jones-UBS Tin Subindex Total Return ETN. ETF Securities offers an ETFS Leveraged Tin security which increases or decreases at twice the rate of the tin sub-index. For equities, the two largest tin producers are Tinmah and Yunnan Tin Company.

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.”

Ceres Global Agriculture Corp, managed by Toronto’s Front Street Capital, has bought 15 grain elevators through the Canadian and U.S. Midwestern prairies, and more recently a railway in Southeastern Saskatchewan that services grain, potash and oil producers.

“It’s difficult to get exposure to agriculture in public markets,” says Gary Selke, chairman and CEO of Ceres, since supply management companies in the agriculture, dairy and poultry sectors tend to be in private hands. “Through infrastructure you can go beyond trading commodities on the electronic exchanges to physically holding them and storing them.”

Where to look

Licensing requirements limit entry points and the complicated nature of the investment strategies are all the more reason to consult a commodity trading advisor or research funds managed by CTAs.

Talk of opportunities in contango and backwardation can scare investors who’ve been burned by dramatic price changes.

But for the right clients, there are plenty of non-mainstream commodities worth considering. Austrup says grain markets are worthwhile.

Who makes a good investor?

The best way to transition into new commodity classes is to start with clients with deep assets and a high tolerance for risk. They will be better placed to accept the volatility in return for more diversified portfolios.

“The more equity exposure you have, [the more open] people are to having a vehicle like this in their portfolios,” says Matthew Phillips, portfolio manager and director, wealth management at Richardson GMP in Guelph, Ont.

But some investors—generally, risk-averse and lower-asset-base clients—will never be comfortable with commodities, so don’t push them.

Investing cheat sheet

Looking to make the case to your clients for investing in non-mainstream commodities? Here are some of the key advantages.

Negative correlation. The extent to which commodity prices can mirror stock market performance can steady a portfolio and protect against volatility.

Play both sides. Investors can bet both the long and short side of commodity prices, which comes with risk but when done well can allow an investor to see growth when everyone else is going down.

Look for mainstream commodity investments in your client’s portfolio. If they are invested in gold, and have done well from that investment, make the case for a less-mainstream commodity investment that the client will see as being a reasonable move from their existing commodity investments. For instance, platinum or palladium—used in catalytic converters—are expected to benefit from growing auto demand in China.

“You want clients to see the logical extension from their existing investments,” says John Stephenson, senior vice president and portfolio manager at First Asset Investment Management Inc in Toronto. “Start slow, and if the client sees some early success you can gain momentum to go further.”

Lastly, stress that even if potential gains sound enticing, any move into non-mainstream commodities will be a slow one due to volatility in this space, which also allows you and your client to test the waters and judge the investment’s relationship with the rest of the portfolio before deciding to move any deeper into non-mainstream commodities.

“Consecutive drought conditions in the Americas caused inventories to drop to critical levels, fuelling a strong price rally in grain markets in the summer of 2012. Supplies are still at critical levels and highly sensitive to weather conditions. We expect to see large movements up or down. Soybeans and corn in particular could offer opportunities on the long and short side.”

Among the Canadian managed futures options are Man Canada AHL Diversified Program Investment, Exemplar Diversified Portfolio and Majestic Global Diversified Fund, while Calgary-based Auspice Capital Advisors Ltd and Acorn Global Investments in Oakville, Ont. also have managed futures offerings. More recently, iShares and Horizons have launched managed futures ETF products.

John Di Tomasso, president of Di Tomasso Group in Victoria, B.C., runs a discretionary long/short commodity fund and has been buying opportunities in tropical commodities such as cocoa, cotton, rubber and orange juice, as well as oats, rice and hogs.

“It’s unlikely they’ll all go in one direction at the same time,” which is why he includes between eight and 15 commodities in his fund. Since 2002, the fund has generated positive returns during 13 of the TSX’s 16 worst-performing months. “It’s a terrific hedge during weak equity months,” he says.

Lack of liquidity has discouraged some investors from straying beyond energy-heavy funds that count their assets in the hundreds of millions or billions, dwarfing the likes of the ETFS Lean Hogs and ETFS Coffee that give investors access to specific soft commodities but count their market capitalizations in the low tens of millions. Coffee, sugar and palm oil are among the soft commodities to which he thinks investors should pay more attention.

Risks to consider

Commodity investing is risky. Prices fluctuate, and investors need to understand the relationship between current and future prices; and how the contract system differs from one commodity to the next.

“The advisor and client need to have an honest heart-to-heart conversation about what they’re trying to accomplish,” says Rebetez.

He warns both sides need to be prepared for significant price swings. For instance, soybean futures have gone up 100%, and down 100% over the past two years.

“The client will see prices up 20% one day, down 20% the next, up 10, down 10 and then make a panicked call to the advisor,” Rebetez says.

Moving into several commodities can help dampen the volatility. But only a bit.

“Over 90% of investors lose money in commodities over the long haul,” says Di Tomasso. “To be successful, you have to know what you’re doing and be patient. Avoid the temptation to tinker.” Christopher Mason is a Toronto based financial writer.