In the late 10s, commodity investments were still unpopular for many large pension funds in the Netherlands. Due in part to years of low inflation, the arguments for investing in metals, grain, oil and other commodities didn't seem worth much anymore. Things are very different in 2023. The general price level has now risen sharply and commodities are the best-performing asset class of the past two years. An interview with Peter Verbaken, head of APG’s Commodities Team.
As an investor of pension money, you invest in commodities for roughly two reasons: the protection against inflation and the diversification it offers to the investment portfolio. For much of the 10s, however, this asset class failed to deliver on both promises. Combined with a long period of poor returns, this led to a decline in the popularity of commodities among pension funds. Understandable, but unwise and not in the interest of the participant, Verbaken believes.
Were the parties who stopped investing in commodities in the late 10s wrong?
“There was a period when diversification did not work as well. During that time, the commodities market was very much driven by monetary policy and commodities moved in part with other asset classes. Perhaps more importantly, inflation protection became almost a fiction for pension fund managers because for a very long time there was simply no inflation. As a result, the argument for inflation protection was put aside by pension fund managers at one point. But in 2021, 2022 and also this year, inflation has been very strong and commodities have been the best-yielding asset class for the past two years. Well, that is exactly why they are in the portfolio. Looking back, there has been recency bias in many funds; decision-making was driven by short-term history, where commodities did not perform well and inflation seemed to be non-existent.”
Commodities include fossil fuels, such as oil. Wasn’t that another reason why some funds removed them from their portfolios?
“They did not explicitly say that. My impression is that the reason was mainly the disappointing returns and the doubt that had arisen about the extent to which commodity investments provided inflation protection and diversification to the portfolio. There has always been discussion around the ESG (environment, social and governance, ed.) aspect, though. That requires a bit more explanation. In fact, we don't buy oil, we buy oil futures: the right to buy oil at a certain price, on a certain date. By being active in this market, we do not provide financing to producers, nor do we cause additional carbon footprint. Were we not to invest in it, it would have no effect on the amount of oil produced. But should a fund still not want oil futures in the portfolio - perhaps more because of the association than because of the actual ESG impact - with the other commodities you are still left with a strategy that makes a valuable contribution to the overall investment mix.”
Geopolitics has changed quite a bit in recent years, with a general realization that Europe has been too dependent on Russia for its energy. What does that mean for an investor in commodities?
“Complete dependence on an autocratic regime for one’s energy needs has indeed proven not to be a good idea - that realization has sunk in very quickly in Europe. Diversifying supply sources is therefore a high priority. With natural gas, this has already been reasonably successful in Europe, although some LNG is still being brought in from Russia. Most of the Russian natural gas has now been replaced by supplies from the U.S., Qatar and Australia, which are fairly large producers.”
What will be the key developments in commodity markets in the coming years?
The biggest, all-important development in the coming decades is the energy transition. The fact that we have to move toward a low-carbon world is going to cause an enormous change in the demand for a lot of raw materials. To meet that demand, production will also have to change significantly. It's also going to cause a huge impact on the geopolitical landscape. Entire regions have made themselves dependent on the export of raw materials for which there will ultimately be less demand. While we will actually see tremendous growth in demand for commodities from other regions. This applies, for example, to metals such as copper, nickel, cobalt and lithium. Electrification is a necessary part of the energy transition, but in order to do so, the infrastructure - the power grid - must be greatly expanded. This requires a lot of copper. And although the ultimate impact of the transition on the demand for fossil fuels is obvious - demand is going down - it is not yet so obvious that that demand is already going down in the short term. Because the construction of all that infrastructure for the energy transition is incredibly energy-intensive, especially since heavy industries such as steel and cement are still dependent on fossil fuels for the time being.”
What does your investment strategy for commodities look like?
“We employ a multi-factor strategy focused on diversification and inflation protection for pension fund clients. To achieve better returns than the benchmark, we use a systematic and model-based approach. This is based on continuous research into new factors and signals that may affect the various commodity markets.”
Can you explain what factors are involved?
“We aim for a good, broad mix of alpha factors, ensuring that you beat the benchmark through different regimes. This includes alternating macroeconomic regimes as well as commodity-specific cycles. Commodity markets are a very specific kind of asset class. Demand is fairly closely tied to economic cycles - although there are a few exceptions - but supply is much less so; it sometimes even moves in the opposite direction to demand. On the supply side, the investment cycle for production capacity plays a role, which can vary by commodity type. For many commodities, there is a long lead time to scale up production or develop new production, and it is very capital intensive.”
Can you give an example of that?
“In the case of a copper mine, for example, from the time the investment is explored to actual production, it can take as long as eight to 10 years. From the time the demand for copper proves greater than the production capacity, it can take a long time for those investments on the supply side to pay off. At the time of actual production, the economy may already be in a different phase, so that in the meantime there may actually be less demand for copper. The economic cycle and the investment cycle of the specific commodity can both reinforce and diminish each other, both to the upside and the downside. That makes it an interesting and fairly unique market, different from, say, the stock or bond market. The different sectors within commodities are almost asset classes in themselves, because they react differently and have low correlation between them. In an equity index, for example, you see relatively high correlation between different sectors and industries.”
How do you find those factors and signals that you base your investment decisions on?
“We have a process of continuous research through which we keep coming up with new ideas, through historical experience and through what we read and hear about what parties are doing in the market. We also keep up with all the scientific literature, based on which we can do our own research project. We also use AI and alternative data sources that can add something to our methods. For example, we recently added two signals developed with Machine Learning models. That way we find signals that work, always wanting to understand the underlying reason why a specific signal works.”
Can you give an example of such an underlying rationale?
“Commodity futures are largely used to hedge price risk, by both producers and consumers. In addition, some investors, such as APG, are also active in the futures market. We seek out price risk precisely because of the inflation protection it provides - we want that in the portfolio. That ratio of producers to consumers varies by commodity market and helps determine how best to execute the futures roll. Based on these kinds of elements, you can look for inefficiencies in the market and take advantage of them by taking a particular position.”
Can you explain what exactly that futures roll consists of?
“The futures we invest in have a specific expiration date. To remain invested in a particular commodity, you have to close the position for a future that is about to expire. At the same time, you have to open a position for a longer-term future. That dynamic of closing and opening a future position - the so-called futures roll - is also woven into the benchmarks. This is done according to a certain method. As an investor, you can deviate from that method. Based on the signals we find and the underlying rationale, we determine what that deviation looks like.”
How does APG’s commodities team’s approach differ from other commodity investors?
“In the Netherlands, the number of large pension funds that invest in it is limited. The smaller to medium-sized funds do invest in it, but often outsource it. In those investment strategies, the focus is often on, say, one or two of the five signals we use. Internationally, there are still many large funds that invest in commodities. But how advanced the approach is varies greatly, and often the emphasis is still more on the short term than the long term, as is the case with us. A number of investors have a predominantly discretionary approach and thus take positions based on fundamental insights. For us, investment decisions come almost entirely from a systematic approach and a quantitative process. Although fundamental insights certainly still carry some weight with us. We always want to know what is going on in the market today, what is driving it. And if, in our view, a particular active position poses a risk because of a market development we see, we can override that systematic and quantitative process, for example by taking a neutral position relative to the benchmark for a period of time. The trick is to determine the right moment when the market risk has normalized again and you go back to your model-based approach and your original position.”