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Institutions Failing Commodity Investors

Financial institutions offering commodity investments during this once-in-a-generation demand boom are failing on two levels: they are not attracting the money they should and they haven't realised that Asia is the future.

Financial institutions offering commodity investments during this once-in-a-generation demand boom are failing on two levels: they are not attracting the money they should and they haven't realised that Asia is the future.

While this may raise the hackles of investment bankers, hedge funds and producers of commodity indices, the numbers do not lie.

There is roughly $30 trillion in global pension funds, yet direct investments in commodities are only a smidgen over $400 billion, which barely qualifies as a spit in the bucket.

It also highlights that, despite the rise of China and India as major commodities consumers, most investors are missing the boat.

At the Commodities Week Asia conference in Singapore this week there appeared to be a fairly large disconnect between the sell and buy sides of the story.

The sell-side guys seemed rather satisfied that total investments in commodities had tripled from less than $150 billion in 2007 to peak last year at around $450 billion.

However, several buy-side fund managers said they were still underweight commodities, not because they didn't believe in the asset class, but because they couldn't access suitable investments.

"If I want to buy the China growth story, how do I do it?" was one question put to me by a British-based pension manager.

Numbers from Barclays Capital show that funds are generally way short of target allocation when it comes to commodities.

So far in 2012, fewer than 25 percent of funds were at 75 percent of target allocation for commodities, down from more than 35 percent last year.

At the same time more than 30 percent were at less than 25 percent of target allocation in 2012, up from around 20 percent last year.

What this shows is that investors are reluctant to put their money into commodities and appear to be getting more so.

While some of this can be explained by the pullback in some commodity prices in recent months, the argument falls down as the prices of other commodities, particularly oil, have risen.

The stronger argument would appear to be that the lack of commodity investments can be explained by the lack of suitable vehicles, a lack of understanding by buy-side managers and perhaps by inadequate marketing and education.

Also, while the commodity boom dates backs to the early 2000s, the investment train really only got going several years later, just in time to capture the boom that turned horribly bust in 2008, burning many early entrants.

The lack of real commitment to commodities is made all the more stark by looking at a breakdown of how the money is currently invested.

At the prevailing gold price of around $1,660 an ounce, about $116 billion of commodity investments is held in gold exchange-traded funds, more than a quarter of the total pool.

While gold has been a stand-out investment since it bottomed around $255 an ounce in 2001, this is perhaps the simplest of all commodity investments and doesn't relate much to the shift eastwards in overall commodity demand.

It is even argued that gold isn't really a commodity, it functions more as an alternative currency and a consumer product.

Going back to the fund manager who wishes to buy the China commodity story, it becomes clear that his options are limited.

Buying oil means taking positions in dollar denominated benchmarks, which give him currency risk. And even though Brent is the marker for about 75 percent of global physically-traded oil, it's hard to see that it's the best way to capture growing Chinese imports.

For copper, it's much the same: the dollar-denominated, and London based, market is not exactly a perfect correlation to the China story.

In iron ore, the swaps market is becoming more liquid, but is still probably not developed enough and perhaps too opaque for a pension fund to invest with confidence. The same goes for coal.

Ultimately, pension funds turn to investing in equities on the view that if you believe China's iron ore demand will continue to grow strongly, it's best to buy BHP Billiton , Rio Tinto or Vale, the big three producers that dominate global seaborne trade.

But the problem with these companies is that the price of the commodities they produce is only one factor in the value of their shares.

BHP Billiton's share price, not including the value of reinvested dividends, has gained 64 percent in U.S. dollar terms since the beginning of 2009, while spot iron ore has returned 105 percent.

Exxon Mobil's shares, again not including reinvestment, are up 7.6 percent since the start of 2009, while West Texas Intermediate crude futures in New York are up 127 percent and Brent crude by 150 percent.

Investing in traditional ETFs won't help you capture the upside of oil either.

The U.S. Oil Fund, which trades in front-month WTI futures and which is up 21 percent since 2009, is susceptible to losses when the futures curve is in contango, and this is a problem common to any investment in a commodity with an upward-sloping futures curve.

Some of this can be overcome with funds that actively manage the slope of the futures curve, but it's also not hard to see why this seems all too risky for pension fund managers.

The solution lies in establishing investment products that switch the focus from Western-centric benchmarks, such as the S&P GSCI commodity index, to Asian benchmarks.

While this is an excellent idea, it is also one that requires several parties to get together to change things.

Banks will to have actively push for changes and work with investors to make sure new products meet the needs of pension funds, and they will have to be patient, as this sort of effort invariably takes time.

China will have to open up its financial markets to allow institutions to trade freely, as this is needed to create liquidity, the lifeblood of any investment vehicle.

All this will take commitment, as well as an understanding of the changing dynamics of commodity demand and its structural shift to Asia.

And while there is talk of a Shanghai-based crude index based on China's oil imports, so far there is little evidence of either commitment or understanding among financial institutions.

(At the time of publication Clyde Russell owned shares in BHP Billiton and Rio Tinto as an investor in a fund and may be an owner of other securities mentioned in this article indirectly as an investor in a fund.)

(Editing by Miral Fahmy)

Copyright 2010 by Reuters. All rights reserved.

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