Part of an interesting article from Barron's on how pension funds are allocating more money to commodities. ______________________________________ The Right Stuff Battered by stocks and bonds, more pension funds are discovering commodities' allure By NICHOLAS ELLIOTT "WHEN MEAT AND POTATOES no longer satisfy, some diners turn to more exotic fare. The same holds for corporate and municipal pension funds, which have found financial assets -- in particular, stocks -- thin gruel in recent years. Now more funds are venturing into the wild and woolly world of commodities in a bid to diversify risk, and boost assets and returns. And the gambit just might work if the bull market in hard assets continues, as many expect, for at least a few more years. Commodities are on a roll, and funds that pioneered in this arena have seen handsome gains. Take the Ontario Teachers' Pension Plan, which allocated nearly $1.5 billion, or 2.2% of assets, to commodities last year, and reaped a 30.4% return. PGGM, the Dutch pension fund for health-care and social-work employees, did even better, scoring a 35.5% return on an investment of â¬1.78 billion ($2.09 billion). Pension funds that have taken the leap typically devote 2% to 4% of assets to commodities. They mostly invest through swap transactions, swapping the gains in a commodity index for interest payments. After a three-year bear market in stocks, it's not hard to see the attraction of alternative investments, commodities included. "You can't simply depend on the market to grow yourself out of problems," says Thomas Schneeweis, a professor of finance at the Center for International Securities and Derivatives Markets at the University of Massachusetts. And the same holds for foreign markets these days, which are more syncrhonized than ever to U.S. stocks." "Still, commodities proponents see a chance to attract more capital from the conservative pension-fund crowd. Commodities, after all, offer more liquidity than real-estate, and less correlation with financial assets than most alternatives. Indeed, foundations and endowments saw the light years ago. "The more savvy, sophisticated investors, such as foundations, have all had allocations to commodities, and it's had a very positive impact on their overall portfolio performance," says Darren Spencer, a research consultant who oversees alternative investments at Aon Investment Consulting. Not that Spencer's expecting pension managers to stampede into oil, coffee, copper and such. "It's going to take time to change people's thinking," he says. The case for commodities in institutional portfolios rests not on their stellar returns but their inverse correlation to stocks and bonds. Several academic studies confirm this divergence, but simple economics lends underlying support. The prices of hard assets, from soybeans to steel, are lifted by inflation, which can be a killer for financial assets. Commodities perform best during inflationary periods, and when interest rates are rising. A wider airing of this argument might explain the rising interest in such investments, says Robert Greer, real-return product manager at Pacific Investment Management Co., or Pimco. "Only recently have people been hearing enough about it, and consistently seeing commodity returns...provide what has been advocated for the last several years: an inflation hedge and diversification," Greer wrote on the Pimco Website. If inflation takes root, says one investment-firm economist, commodities could deliver "more bang for the buck" than, say, Treasury inflation-protected securities, or TIPS. On the other hand, he adds, "If we do not see more inflation, and global growth is moderate, commodities don't offer any yield and could deliver disappointing returns." By any measure, commodities have been stars in the post-Bubble era, after years of subdued returns. Prices for many agricultural products, metals and other raw materials, including oil, have hit multiyear highs, spurred in part by China's emergence as an economic power. Supply disruptions, too, have contributed to the gains. Strikes and political unrest have curtailed oil supplies, bad weather has trimmed grain production and disease scares have limited livestock trade. Most institutions invest through a commodities index, which provides exposure to various markets without requiring knowledge of each. The Ontario Teachers' fund, for example, invests through the Goldman Sachs Commodity Index, or GSCI, which weights 26 commodities by size, according to their world production. "We don't have any particular expertise in managing commodities, but we like it as an asset class," says Bob Bertram, executive vice president of investments at the OTPP. The attraction of the GSCI, he adds, is that it captures returns from backwardation -- the premium pricing of nearby contracts compared with deferred contracts -- a situation that occurs in markets where current supplies are tight. As expiring GSCI contracts are "rolled" forward, a monthly event known as the "Goldman roll," the pricier contracts are sold and cheaper ones bought. Some $12 billion to $15 billion is now tied to the GSCI, compared with $3 billion in 1997. Most of the investments are from pension funds, insurers and foundations, says Heather Shemilt, head of marketing for the index. The GSCI returned 69% in the five years through September, compared with the Standard & Poor's 500's total return of 5%. New products allow institutional and retail investors to invest in commodities without having to make direct purchases of pork bellies or orange juice. Pimco last year launched the Pimco Commodity Real Return Fund, attracting $460 million, mostly from institutions, through mid-September, says Greer. The strategy matches investments against the Dow Jones-AIG Commodity Index, published by American International Group and Dow Jones (which also publishes Barron's). The DJ-AIG weights 20 commodities by liquidity and output. Deutsche Bank also launched a set of commodities indexes earlier this year. The Deutsche Bank Liquid Commodity Index consists of the six biggest commodities in terms of global production and inventory -- crude oil, heating oil, aluminum, gold, wheat and corn -- each assigned a constant weighting. The Deutsche Bank Liquid Commodity Index-Mean Reversion varies those weights according to the deviation of each commodity from its long-term average price. Retail investors can buy Pimco's fund, as well as the Oppenheimer Real Asset fund, with assets of $330 million, which returned an average annual 8.42% in the past five years, according to Morningstar. The Van Eck Global Hard Assets Fund, with assets of $52 million, and five-year returns of 10.07%, is another option. Investors also can trade GSCI futures at the Chicago Mercantile Exchange, or DJ-AIG futures at the Chicago Board of Trade. Commodities remain exotic stuff for most pension funds, with the small wave of converts standing out. The Pennsylvania State Employees' Retirement System had $325 million matched against the GSCI in 2002, its second year in this market. The Missouri State Employees' Retirement System has invested in the GSCI since 1998 and now has $127 million indexed against it. In the Netherlands, Stichting Pensioenfonds ABP, one of the five largest pension funds in the world, raised its commodities allocation to â¬2.535 billion in '02 from â¬185 million in 2001. For the $15 trillion pension-fund industry, such investments represent small change. But for the commodities markets, even a few droplets from this vast pool could be a significant boon, beckoning even more funds to brave the pits."