Finding talented risk managers is the next big challenge to commodities funds as investors no longer need convincing on the asset class but want to minimise the risks historically associated with commodities.
The global commodities train is chugging along, adding billions of new investment dollars each year, but reaching a new plateau will depend on the skill of portfolio managers in reading pitfalls early and turning them to advantage, said industry experts grouped at a conference in this US south-eastern resort.
"In a commodity futures trading programme, a manager can easily adjust his or her leverage level to magnify gains or losses," said Hilary Till, principal at Chicago-based Premia Capital Management. "Therefore, proprietary investment strategies may not be the most important element of an investment process."
"Instead, how a manager implements a program's portfolio-construction and risk-management may be what is most important," she said. "This is what determines if a program can stay in business during inevitable, dramatic market moves."
She illustrates with a quote from hedge fund manager, who has more than $5 billion under management: "Other people have the same information I do; other people put on the same trades as I do. I make money; they don't.'"
The bulk of the money invested in commodities these days comes from hedge funds, pension funds, endowments and wealthy individuals who mostly prefer passive investment instruments such as the Goldman Sachs Commodity Index and the Dow Jones-AIG Commodity Index.
These indexes cover a broad range of commodity futures. They strive for long-term returns through a measure known as "beta," a gauge of volatility, or systematic risk, for an asset or a portfolio in comparison to the market as whole. A beta of 1 indicates that the asset's price will move with the market while anything below means that the asset will be less volatile than the market.
On the other end of the spectrum are fund managers who take active positions in specific commodities, buying even physical spot contracts, to ensure investors get absolute or abnormal returns known to the industry as "alpha."
An alpha of 1 means the asset has outperformed the market. A positive alpha is the extra return awarded to the investor for taking additional risks rather than accepting market returns.
The market based on the alpha measure is small and growing slowly.
"And that's because commodity markets have a history of being risky," said Brad Cole, president of Cole Partners, another Chicago-based assets manager. "Ten years ago, the ability to access commodities markets was strange. The bad part was that commodity brokers back then would take a discretionary call on commodities and would put their clients in that discretionary call and quite often, charged big commissions too.
"There's a much higher degree of sophistication now in the business and there are people who have really increased their abilities to become skill-based managers or hedge fund managers to look for alpha opportunities," Cole said. "The problem is there's not a lot of them."
That means if there's an infusion of money into the market, the action would remain in passive index investing.
"What I really see is the large flows are going to be for the broad-based indexes themselves, not just for agriculture, not just for energy," said Bob Greer, senior vice-president at Pimco, one of the world's largest specialty fixed income managers which handles more than $590 billion in assets.
"But you will have specialty active fund managers - the hedge fund type of people, the absolute return people" eyeing some of that money, said Greer, who oversees real return products at Pimco, whose clients include pension funds, foundations, endowments, corporate treasuries, financial intermediaries and wealthy individuals.
Till of Premia Capital said active commodity managers had to examine the worst performance of a strategy under similar circumstances in the past and decide how much to leverage that in the present. But if the strategy failed, a quick exit was needed.
"One would not suggest doubling down in the face of extreme losses. In the financial markets, this has proven to be a profitable strategy. In a crisis, the US Federal Reserve Board has tended to decrease interest rates, flooding the system with liquidity, which has stabilised the returns of financial market strategies."
And while there may be no correlation between commodities and other asset classes such as equities and treasuries, there was certainly a link in the price behaviour of certain raw materials from the effect of weather and financial policies.
Another was the sudden slide in Chinese demand for platinum and copper - both industrial metals - after reports in April 2004 of a more stringent official policy towards industrial loans in that country.
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