Investec Enhanced Natural Resources fund

Commodities have moved rapidly up the investment pecking order in recent years, backed by obvious fundamentals plus diversification benefits away from equities and bonds. Much of this has been down to close links with the burgeoning emerging markets story, with their growth – combined with infrastructure renewal in developed economies – driving commodity demand.

Investors who invest in supply-constrained commodities will be rewarded.

History however shows returns from individual commodities can be volatile, meaning choice of product is particularly important in this space. While there have been commodity funds around for years, Investec started a fresh trend in the market with its Enhanced Natural Resources launch in 2008 by employing Ucits III powers.According to the group, active management is key to accessing rising commodity prices but also reducing the impact of falling markets. Managers Bradley George and George Cheveley can take long and short positions, investing across direct commodities – via exchange-traded vehicles – and resource equities. In the four and a half years since launch – taking in the depths of 2008 – Enhanced Natural Resources has produced total returns of 11%, or 2.5% a year, against relative figures of -3% and -0.7% from the 50% MSCI AC Energy and 50% MSCI AC Materials composite benchmark.

The macro effect

Looking at the macro backdrop, George says eurozone fears continue to dominate, compounded by a slowdown in Chinese growth. “Commodity prices have generally fallen as global growth has slowed and many have moved into oversupply, at least temporarily,” he adds. “This has also led to equities in the sector weakening as analysts reduce medium-term price forecasts and concerns increase of a prolonged slowdown.” George and Cheveley believe many assumptions used are too bearish for two reasons.First, the effect of a European crisis on commodity demand may not be as large as the market perceives, with China far more important. Taking steel for example, Europe’s demand has grown from around 210 metric tonnes (mt) to 250mt over the last 15 years, but its share of global demand has fallen from 30% to 16% as China’s has ballooned. “Even if we assume European steel demand were to fall 10%, this now only represents a 1.6% drop in world demand compared with 3% 15 years ago,” adds George. “With signs of China loosening monetary policy again and approving more fixed asset investment, demand for several commodities, particularly steel-making raw materials, could hold up and even strengthen again despite a European recession.”Second, due to growth in demand over the past decade, more expensive marginal producers have got involved and this has led to steeper cost curves. As a result, George says many commodities are already at a level that means some of these producers are shutting down, which will support much higher prices than in the past. “In the short term, persistent uncertainty could cause a sell-off in risk assets but with resource equities already falling back over the past year, they are factoring in commodity prices below that of fundamental support levels,” he adds.On the more negative side, George notes concerns about the fiscal cliff approaching in America and slowing growth in China, with ‘political negligence’ also harming India’s economy. “As the rupee reaches all-time lows, Indian jewellery demand for gold continues to stumble, weak policy is dragging on infrastructure build, and this currency depreciation will likely only exacerbate the country’s price-sensitive consumption of coal and fertiliser,” he says. “Recent opposition party and trade union protests against the 10% rise in petrol prices indicate any liberalisation of the market will be difficult.”

Adjusting exposure

Against this backdrop, the managers have recently brought down gross exposure on Enhanced Natural Resources from 113% to 95%, also cutting the net to just below 40%.Most of the positions are equities (with 85% shares and 10% direct commodities making up the 95% gross), with Rio Tinto and Potash the largest stakes. Of the equity exposure, the split is around 75/25 long short, with a more even balance on the direct side.At country level, the US and UK remain the largest positions, at 31.8% and 26.4% respectively, with the balance spread across Canada, Europe and Australia. “In this uncertain environment, investors who protect themselves from sharp pullbacks and invest in supply-constrained commodities with stable, low-levered and strong cash-generating companies will be rewarded,” adds George.Overall, he says significant falls in April and May have made resource equity valuations compelling, especially compared with commodity prices and the rebound at the end of June.