In July, Nest set industry tongues wagging when it awarded a mandate to a specialist fund firm to invest in commodities on behalf of its 6.9 million members.
The DC master trust said that the fund would become one of the “asset class building blocks” in its default strategy, where almost all its members are invested.
Core Commodity Management, the fund group that won the mandate, claimed that the move would assist in providing “portfolio diversification” and “inflation protection” in the media announcement made at the time. However, Nest’s decision to introduce commodities into the wider asset mix of its default strategy has raised questions among industry commentators about how successful the asset class might be in diversifying a portfolio.
Former Aviva fund operations manager, Rory Gravatt, who now works as a consultant for Altus Consulting, was among those to feel uneasy by Nest’s decision.
He said: “Moving more of the portfolio out of cash and short- term bond holdings is a logical step by Nest to avoid inflation eroding the value of the scheme assets, but the use of commodities makes me uncomfortable.
“The biggest challenge for the Nest mandate is the balance between the volatility of individual holdings and diversification within the asset class. Too much focus and the mandate is in the volatility equivalent of the Wild West, too little and any real inflationary protection and performance being sought is lost.”
Gravatt’s volatility-related observations were echoed by some of those with whom Corporate Adviser spoke for this article.
Barnett Waddingham head of DC investment Sonia Kataora says that volatility was likely the reason why other DC schemes have opted to avoid commodities as an asset class.
“We have not seen many DC schemes adopt a strategic allocation to commodities” she says. “Part of the reason is their inherent volatility, which tends to be higher than in equites, bonds and more traditional assets used in DC schemes.
“Performance has also been mixed in recent times, although during a period of muted global inflation, it is unsurprising that an asset meant to hedge inflation has underperformed.”
So, is Nest wrong to award a dedicated commodities mandate? Not necessarily. The organisation awarded the mandate as part of a wider change in its investment strategy, as it prepares to see its current £200m of monthly contributions double from April next year.
The company’s chief investment officer Mark Fawcett says that a more strategic approach, which included segregated mandates as well as pooled funds would allow cost-effective access to new sources of return without increasing members’ investment risks.
Some in the industry have applauded the move by Nest, saying that there is indeed a role for commodities in default funds, albeit with some caveats. Among them is Patrick Connolly, spokesman for corporate advisory group Chase de Vere.
Altaf Kassam, head of strategy & research, Investment Solutions Group at State Street Global Advisors, agrees that commodities could offer benefits to DC portfolios.He says: “Commodity prices do generally behave in a relatively uncorrelated way to other growth assets like equities, which means they have the potential to lower overall risk when added to a portfolio.
“They can be seen as a ‘real’ asset with positive exposure to inflation, so can be used to impart some immunity to a portfolio if rising inflation is a concern. This sets them apart from e.g. long duration government bonds, which have a similarly low correlation to equities but which would likely suffer in the face of sharply rising inflation expectations.”
While the thinking behind Nest’s commodities allocation has received a thumbs up from some market commentators, others have explained that the absence of such a move by other DC funds is symptomatic of onerous platform requirements which have stifled innovation“The limitations of DC default fund design have not been helped by the platform requirements for daily pricing and liquidity,” explains Newton Investment Management head of DC pensions Catherine Doyle.
“A lack of scale in DC has meant that schemes have chosen not to make separate allocations to less traditional asset classes, although this is beginning to change as some of the larger, more sophisticated schemes seek to further diversify their sources of return,” she added.
Doyle says that, as DC schemes increase their scale and sophistication, there will be an increasing need to integrate asset classes that are less than perfectly correlated.
On top of all these considerations is a further challenge of integrating sustainable investing principles into any new asset class that is brought into the mix. This is where Nest’s decision becomes even more interesting, when you consider the constraints it placed around the mandate.
The segregated fund has been designed to match Nest’s environmental, social and governance requirements, and is matching the exclusions in the master trust’s climate aware fund. This means no investments in energy producers deemed to have the highest exposure to climate risk, such as coal.
Producers that have the bulk of their activities based on the production of thermal coal, palm oil, uranium, tobacco or in cobalt mining in the Democratic Republic of Congo will also be excluded.
This long list of restrictions has divided opinion among corporate advisers, who question whether this will make a significant dent in returns.
“Nest is imposing limits to appeal to the ESG audience, but these may pose a real headache to driving returns,” explains Altus Consulting’s Rory Gravatt.
“The Bloomberg Commodity Index that the mandate has been set to outperform shows a predominance of fossil fuels, livestock and agriculture holdings.
The first two are the biggest contributors to global warming, and the third hits right in the sweet spot of palm oil farming.”
The difficulties in delivering sustainable investment metrics within a commodities mandate has seen many schemes avoid it altogether, preferring, instead, to gain exposure to commodities through diversified growth funds. More recently, others have opted for real asset funds, whose characteristics could be argued to offer an appealing alternative for DC funds that were originally considering a strategic commodities allocation.
“The decision by Nest to invest in commodities may change this trend,” says Barnett Waddingham’s Sonia Kataora. “So too may the outlook for the equity market, which has seen investors increasingly look for alternative drivers of re turn.” Kat aora exp lai ns t hat commodities could yet become more popular as DC funds recognise that they offer a fairly- priced link to global economic growth. Her observations were echoed in a 2018 report from Neuberger Berman, which said that global growth and commodities performance tended to go “hand in hand”.
According to the US fund group, demand for commodities spikes, when output gaps close globally, and economies start to operate over capacity.
Data in Neuberger Berman’s report suggests that currently, fiscal expansion is underway in nearly all the world’s economies, which augers well for allocations to the asset class in the immediate years ahead.