Choosing Commodities: Why the majority of investors still choose passively

The latest report from the Investment Management Association shows that commodity fund sales are currently running at their highest level on record. They sold £208m in November alone. Investors have been lured both by the prospect of another bumper year as emerging market demand rises and also by the threat of inflation, against which commodities offer some protection.

A case can be made either way for investment in commodities, but for investors wanting to gain exposure to their potential growth, the key issue will be whether to take an active or passive approach. This has been under discussion on Schroders Talking Point this month, which makes the case for an active approach.

At the moment, this is the exception. As this FT article shows, the majority of investors still take a passive approach to commodities investment in spite of the relatively strong performance of active managers in this area. However, there are signs - particularly at the institutional end of the market - that this is changing.

Schroders makes the point that passive investments do not always track commodities prices effectively. The use of rolling futures contracts can distort the overall price achieved, leading to significant long-term differences in price. Investors are vulnerable to being buffeted by the caprices of speculators, which are particularly numerous in commodities trading. Arbitragers can take advantage of the predictability of passive money. 

That said, a passive approach does have its advantages. It is cheap, liquid and easily accessible. Investors can gain access to almost any commodity, or basket of commodities they choose. Page 17of this report shows the range of commodities ETFs available and the weight of money that backs them: . There has also recently been the emergence of 'intelligent' passive approaches to commodities investing, as highlighted here . 

An active approach will often depend on the skill of the fund manager. If he picks well, a commodities company will often perform better than the underlying commodity. It may be able to mine more efficiently, or leverage its position, or it may have a strong distribution network. However, the reverse is also true - a weak manager may pick companies that do worse than the underlying commodity through poor management or bad risk controls, for example.

 This piece examines the arguments for active and passive investments, many of which apply to the commodities markets. It concludes that a portfolio should include both types of investment - each trying to do a slightly different thing.

One thing is clear - active commodities funds do not tend to be 'quasi-passive' as is the case with many equity funds, so at least investors do not have that risk. Passive commodities vehicles tend to be blown about by fund flows and, as such, investors should be prepared for a rougher ride. As ever, there are advantages to both approaches and investors need to decide the type of risks they want to take.