ClockWise: Commodities in a multi asset fund

We have included commodities in multi asset funds at Royal London since 2016, making us one of the largest commodity investors in the UK.

As with other core asset classes, we pay attention to the strategic case for investment as well as shorter term tactical drivers. Likewise, we look to blend passive exposures with active strategies that consider environment, social and governance (ESG) factors where possible.

Commodities improve diversification, often posting their best returns when stocks are struggling, and they bring inflation resilience to a portfolio. Both characteristics were strongly in evidence during the stagflation shock of 2022, with commodities returning around 30% to a sterling-based investor (for a second year running) while a global stock index fell 8% and a gilt index fell 24% (Figure 1).

Figure 1: Different asset classes outperform at different times

Past performance is not a guide to future performance. Source: Royal London Asset Management, LSEG DataStream as at April 2024; property as at March 2024. ‘Multi Asset’ returns are based on the benchmark weights of Royal London Global Multi Asset Portfolio (GMAP) Balanced Fund / Governed Portfolio 6. Indices used are FTSE All Share, FTSE World, MSCI Emerging Markets ESG Leaders, MSCI/AREF UK All Balanced Quarterly Property Fund, Bloomberg Commodity Index, BoAML BB-B Global Non-Financial High Yield Constrained Index, iBoxx Sterling Non-Gilt Index, Bloomberg Barclays Global Aggregate Corporate Index, FTSE Actuaries UK Index Linked Gilts, Bloomberg Barclays UK Government Inflation Linked Bond 1-10 year Index, Bloomberg Barclays World Government Inflation Linked Bond (ex UK) 1-10 year, FTSE Actuaries UK Conventional Gilts Index, JPM Global ex-UK Traded Index, FTSE Actuaries UK Conventional Gilts up to 5 Years Index, SONIA. Total returns in sterling terms.

We typically allocate around 5% of a strategic asset mix to commodities and this applies to funds whether these have a low, medium or high risk budget – all need resilience to inflation. As active investors, we can flex our commodity exposure, with most funds able to double exposure from its strategic weight or, potentially, to remove it altogether as conditions dictate.

Over a tactical timeframe, commodity prices respond to supply and demand. Supply is tight almost everywhere you look. Fossil fuel producers are responding to net zero by cutting capital spending, which limits the amount of spare capacity in the system when a shock comes along. Supply is similarly constrained for metals like copper, which will play a crucial role in transition. Added to this, a volatile geopolitical backdrop can mean a sudden interruption of supply, as we saw with Russian oil sanctions and may see again if there is broader conflict in the Middle East.

Economic activity is the key driver of demand. With global growth more resilient than expected and inflation sticky, the Investment Clock model that guides our tactical asset allocation has moved into Overheat, the phase of the business cycle characterised by above trend growth and rising inflation – the phase in which commodities tend to be the best performing asset class (Figure 2). Economic  data releases lately have been mixed, but it’s not hard to imagine a further pick-up in global manufacturing pushing us further in this direction. The recent sharp increase in the price of copper suggests a new period of strength may be underway.

Figure 2: Investment Clock has moved into Overheat

Source: Royal London Asset Management. For illustrative purposes only. Trail shows monthly readings based on global growth and inflation indicators. Yellow dot shows where we are now.

We benchmark our commodity exposure to the Bloomberg Commodity Index, a broadly diversified basket of 24 individual commodities. We like this index as risk is spread across the complex, with roughly one third allocated to energy, one third to agricultural commodities and one third to industrial and precious metals (Figure 3).

Exposure to each commodity is linked to the same futures contracts that producers and consumers of commodities use to agree prices for delivery at a future date. However, as financial investors, there is no risk of ever having to take delivery as the futures backing investment in a commodity index are automatically rolled to longer dated contracts as they approach expiry.

Figure 3: Bloomberg Commodity Index, diversification within the asset class

Past performance is not a guide to future performance. Source: Bloomberg as at 6 May 2024. 

Most of our investment is through instruments that track the index. However, we also invest in systematic strategies that look to enhance returns by rolling underlying commodity futures at different points in the calendar curve where the roll cost is lowest, or the profit greatest. From time to time, we also take additional exposure to individual commodities such as gold.

We actively look for ways to improve ESG consideration in our equity, fixed income and property investments, and commodities are no different. Unlike a holding in shares, commodity futures don’t confer partial ownership of a business and don’t come with a vote. On one level, as multi asset investors, we are well placed to influence the ESG issues involved in the production and consumption of commodities through the shares we hold in the companies involved. We wanted to go further than this, so we worked in partnership with Bloomberg in a year-long collaboration leveraging our experience developing and launching carbon-tilted equity funds.

Figure 4: Steps to carbon tilting

The outcome was the creation of a carbon-tilted commodity index (Figure 4) and the launch of an ‘Article 8’ commodity Exchange Traded Fund, of which we are a cornerstone investor. This initiative marks a first step in bringing ESG factors into commodities investing. We expect more positive changes to follow in an asset class that is becoming increasingly part of the mainstream in the more inflationary era we are living in.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.