Stockholm (HedgeNordic) – Commodities often behave differently from traditional financial assets due to their cyclical nature, as their performance is heavily influenced by the dynamics of supply and demand. This cyclical characteristic often relegates commodities to a secondary role in long-term institutional portfolios. While some consider commodities as nothing more than a speculative gamble in the market timing game, others consider them a fundamental pillar of their portfolio allocation. For example, two prominent Danish institutional investors, Velliv and ATP, view commodities as strategic allocations within their portfolios, considering them essential for diversification and inflation hedging.
At Velliv, Denmark’s third-largest commercial pension company, commodities are seen as a classical diversifier. “Our allocation to commodities is a classical ‘diversifier,’” says Christoph Junge (pictured left), Head of Alternative Investments at Velliv. Although “many commodity prices tend to fall in real terms due to productivity increases” over the long term, according to Junge, “there are certain periods of price spikes in between – such as 2022 – when an allocation to commodities adds a lot of value.” Gold, often considered a separate asset class, is also known for its inflation-adjusted positive returns over the long term.
“Our allocation to commodities is a classical ‘diversifier.’”
Christoph Junge, Head of Alternative Investments at Velliv.
The lack of correlation among commodity sub-sectors further enhances the diversification attributes of commodity investments. “We have chosen to invest in a broad range of commodities to get the best diversification,” notes Junge. He emphasizes the role of precious metals in providing diversification and inflation protection, especially during periods of monetary inflation. “In the event of monetary inflation, where one’s currency becomes less valuable (amid loose monetary policy) and imported goods thus more expensive, gold (precious metals) has historically been protective of returns as it maintains its purchasing power,” he explains.
In contrast, during real economic inflation where demand exceeds supply, investing in other commodities such as energy and industrial metals can offer more protection. “In real economic inflation, where demand exceeds supply (loose fiscal policy), the most protective is to invest in the commodities that are in deficit and thus cause the price increase, including energy and industrial metals,” he elaborates. Equally important, Junge points out that “industrial metals are also indispensable for the goal of realizing the green energy plans, as larger quantities must be used than are currently available.”
Commodities offer similar portfolio benefits for Denmark’s largest pension fund, ATP. While Christian Kjær (pictured right), Head of Liquid Markets at ATP, does not observe “a very strong link between the return on commodity futures and inflation” on average, “we do however expect the commodity portfolio to provide some mitigation in inflation tail shocks scenarios where we expect to incur losses on both equities and bonds.” In normal market conditions, however, ATP views commodities as a diversifying return driver and a core component of their portfolio, which is structured around risk factors.
“We do however expect the commodity portfolio to provide some mitigation in inflation tail shocks scenarios where we expect to incur losses on both equities and bonds.”
Christian Kjær, Head of Liquid Markets at ATP.
“Commodities represent a strategic beta allocation in our portfolio,” says Kjær. Commodities, along with inflation collectively comprise ATP’s inflation factor. “In the beta allocation, commodities act primarily as a diversifying return driver,” reiterates Kjær. He also highlights that a well-diversified commodity portfolio is expected to have about half the long-term risk-adjusted return of a diversified equity portfolio. Equally important, the team at ATP “expect commodities to provide some inflation tail-risk shock mitigation, with the period from summer 2020 to winter 2022 serving as a prime example.”
How to Invest in Commodities: Avoiding the Negative Roll
Similar to ATP, Velliv also views commodities as a core component of their asset allocation. “Commodities are part of the strategic asset allocation,” says Junge, who notes that their allocation to commodities is modest. In addition to its long-only commodity exposure, Velliv maintains some exposure through its CTA (Commodity Trading Advisor) portfolio. “This can be seen as a more tactical exposure due to the fact that CTAs take both long and short positions,” explains Velliv’s Head of Alternatives. The long-only exposure is achieved through exchange-traded funds (ETFs). “We have chosen to have both a long-only exposure and the more tactical exposure through CTAs to be sure that we do have a long exposure during a rapid increase in inflation.”
“We have chosen to have both a long-only exposure and the more tactical exposure through CTAs to be sure that we do have a long exposure during a rapid increase in inflation.”
Christoph Junge, Head of Alternative Investments at Velliv.
Junge emphasizes the importance of maintaining exposure through both long-only ETFs and trend-following CTAs to maintain commodity exposure in different market environments. “In the early days of rising inflation, CTAs might not have a sizeable allocation due to the lookback period in the models,” Junge notes. “On the other hand, CTAs will balance the commodity exposure during the not-so-good times for long-only commodities,” he continues. “ETFs are a cheap and easily accessible way to get commodity exposure.” Velliv has specifically chosen a semi-active strategy through roll-optimized ETFs.
One challenge of investing in commodity markets via futures is the potential for negative roll returns over the long term – resulting from the costs associated with holding the underlying assets, which can erode total returns. “Commodity exposure can very seldom be achieved via spot markets (gold being one exception) and is mostly achieved via futures,” explains Christoph Junge of Velliv. “When commodities trade in contango (i.e. where the spot price is lower than the futures price), this introduces a negative roll yield when the futures contract has to be rolled over due to expiration,” he elaborates. To counter this, Velliv has opted for a roll-optimized ETF, which seeks to mitigate the negative roll effect. “We have compared actively managed commodity funds with these roll-optimized passive (or semi-active) products and found that they do compare very well,” says Junge, “especially given that the passive products are much cheaper.”
“We take a passive approach on the beta allocation, and a more active one in the Quantitative Investment Strategies (QIS) area.”
Christian Kjær, Head of Liquid Markets at ATP.
While Velliv accesses the commodities space through ETFs and CTAs, ATP uses only commodity futures for their liquidity, flexibility, and efficient cash usage. ATP also employs both active and passive strategies in its commodity investments. “We take a passive approach on the beta allocation, and a more active one in the Quantitative Investment Strategies (QIS) area,” says Christian Kjær of ATP. “The reasoning is that we view commodities as a long-term diversifying return driver and also see their application in the QIS space.”
Commodities offer two significant benefits within a broader investment portfolio: diversification and inflation hedging. When managed properly, commodities can be attractive for their return potential over both short- and longer-term horizons. “The primary reasons to invest in commodities are for inflation protection and diversification during inflationary shocks,” concludes Junge. “2022 was a pretty good example.”
