Commodities Investment

Futures and indices versus equities: what is the most appropriate instrument?

TIM MEDLAND, PORTFOLIO MANAGER, GLG PARTNERS LP

There no longer appears to be any debate as to which geographic region or countries will have the strongest growth going forward. The compounding effect of Chinese and Indian growth continues to place them in an ever more important global position. Clearly the thing to do as an investor would be to gain exposure to these areas by buying Chinese and Indian equities.

However, there is an alternative route, and one that is perhaps more liquid and appropriate for many investors, to gain exposure to the specific areas where pricing is reflected by those expanding economies rather than by the more sluggish western ones, namely commodities.

High quality commodity equities are a pure play on emerging economies, but also a levered one. Their leverage comes not only from the ongoing increase in demand as these economies expand via industrialisation and urbanisation, but also because these companies have long term reserves, ongoing exploration and mineable higher cost deposits they can take advantage of if appropriate.

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That brings us very importantly to duration. To take advantage of a secular theme, you need long duration assets, and these companies with their 25-40 year mine lives represent the ultimate in that category. Their listing on major exchanges ensures that they have had to meet stringent listing requirements.

They also represent the most diversified method of accessing commodity markets. Of the four groups of commodities – energy, base metals, precious metals and agriculture – to date the area most profoundly affected by Asia has been the base metals space. China represents the dominant consumer of many of these metals: this year, for instance, it took in some 65%-70% of the 900 million tonnes of seaborne iron ore produced for its vast steel needs.

This year we have also seen China materially changing the anticipated dynamics of the copper and coal markets. Some of these commodities can be traded via futures, but many cannot. There are now some relatively illiquid iron ore contracts for investors, but less accessible and vitally important materials such as many types of coal, potash, uranium, cobalt, ferrochrome and rare earths can only be traded via equities. In addition we have the flexibility to invest up the value-added spectrum towards the finished products.

As the needs of China and increasingly India change, we can alter the spectrum of investments to reflect those developments. This year we have seen the fertiliser space lag as anticipated demand and consequent pricing did not feed through, but we believe this to be a pause in a long term theme. As we have seen this year with iron ore, much to the dismay of the principal consumer, the pricing power remains with the producer.

As we saw last year when the sector went through a vertiginous 80% plunge from peak to trough, the secular theme still allows plenty of room for major pullbacks. This is another reason why we view large capitalisation equity commodities and a long/short fund based on them as an appropriate and relatively less volatile way to engage with the theme.

The diversification afforded by the multiple companies and their respective commodities, and by the ability to short the more expensive stocks within the space, allow for participation on the upside while mitigating the downside risks. With a sector which averages volatility in the region of 50% annualised, this would be important for even the most ardent long term bull.

We believe that sensibly managed commodity equities offer as much of a viable, liquid diversification instrument as commodity indices and futures programs with the added advantage of being a familiar, long duration asset.

Tim Medland joined GLG in 2004 and is the Portfolio Manager of the GLG Global Mining Fund. Prior to this he had a 24-year trading career in financial markets.