By Commodity Online
Even though commodities markets have prevailed for a longer time as compared to other asset classes, only recently have its investment capital risen to levels that of popular asset classes such as equities and currencies. Commodities markets have equalled and even surpassed, in some cases, returns from other asset classes and it ticks all the check boxes for being an ideal investment.
A report from Bank of America-Merrill Lynch (BofAML) highlights the changes in the investment mix of US pension funds, which held 90 percent of investments in cash and fixed instruments back in 1950. However, currently the same pension fund has decreased its investment in cash and fixed instruments to a mere 37 percent. More recently, the pension funds have included commodities, equities, real estate, private equity etc.
The same report estimates that the investments affiliated to commodity indices climbed to all time high last month, recording an increase of 50 percent per annum during last three years.
However, the problem that fund managers face while including commodities in investment portfolios is the difficulty to gauge the long term expected returns from the sector. If one considers historical returns to calculate expected returns, comparative performance of commodities was better over the last thirty years.
But historical returns method fails to calculate the expected long term returns in a comprehensive manner since investment in commodities does not generate income. Commodity investment performances are also not fully tuned to the performance of the underlying asset as long term investment involves additional costs such as storage, insurance, transport etc.
The BofAML report argues that a way to determine expected long term returns would be to consider interest rates. That is, expected price rise and the expected rise in costs are determined together, which approximately becomes at par with the interest rates, the BofAML report argues.
The report also mentions the difficulty of making small increments to investment in production capacity and the resultant reluctance of make large investments. Thus, as an effect, we see commodities trading in ranges for long periods of time and there are also commodity “super cycles”.
Commodities prices were stuck in ranges all throughout the 1980-90’s, mostly due to underinvestment in the productive capacity. Subsequently, the demand for commodities had surpassed the prevalent production capacity. Nevertheless, requirement for production capacity is still high, but the spot price appreciation needs to be significant enough to incentivize producers to invest in production capacities of commodities, BofAML report iterates.
The strong economic growth in the coming years and the rising importance of emerging markets are expected to put upward pressure on commodities prices. The BofAML report pointed out that 40 percent of the poor countries had contributed 21 percent of the world GDP during 2000-2007 as opposed to 13 percent during the 1990’s. The supply of commodities, on the other hand, will rise only if the expected returns are high enough to incentivise investment in production capacities.
