“There is a very easy way to return from a casino with a small fortune: go there with a large one.”
Jack Yelton
I promise you – no mention of Greece in this month’s letter. Over the past few months, I have been eating it, drinking it and sleeping it to the point where I need a break. Instead I will focus on another issue close to my heart – commodities. In last month’s Absolute Return Letter I raised a yellow flag concerning the short term outlook for commodities[1]. Quite a few readers asked me to elaborate on that, which is precisely what I am going to do. In the following, my assessment will be based on the following three observations:
- Financial demand is growing much faster than industrial demand;
- The Chinese have aggressively stockpiled over the past 12-15 months;
- Most investors do not understand the complex nature of commodity investments.
Rising demand
Let’s begin with the rapidly rising demand for commodities from financial investors. Their allocation to commodities has grown dramatically in recent years – to the point where commodities have become a mainstream asset class. According to Barclays Capital, total commodity linked assets under management grew 36% last year to $257 billion, with ETP[2] programmes growing even faster (+48% to $92 billion).
Chart 1: Worldwide Commodity Assets under Management
|
Commodity AuM |
31/12/2009 |
|
ETP Programmes |
$92bn |
|
Index Linked Programmes |
$111bn |
|
Other Programmes |
$54bn |
|
Total |
$257bn |
Source: Barclay’s Capital, Financial Times
Investors typically allocate to commodities in order to:
(i) further their portfolio diversification;
(ii) generate absolute (presumably uncorrelated) returns; or
(iii) benefit from the growth of emerging economies – first and foremost China.
Chart 2: Why Invest in Commodities?
Source: Barclays Capital
Again, according to Barclay’s research, investors have an affinity for ETPs. Only a few years ago, commodity linked ETPs were a rare phenomenon; however, in recent years it has grown to become the product of choice for many commodity investors (see chart 3). Not a smart choice. Here is why.
Chart 3: The Choice of Product
Source: Barclays Capital
Beware if you are the market
Many commodity markets are surprisingly small and index linked products such as…
