be_ixf;ym_202007 d_09; ct_250

Making the Case for Natural Resources Investing

July 11, 2017  | by Ethan Levine, Paul Von Steenburg

Asset Allocation | Investment Strategy | Private Capital | Real Assets

The natural resources sector is often characterized as cyclical, as producers and service providers experience underlying exposure to and commensurate volatility of commodities in the oil and gas, mining and agriculture sectors. After a couple of years of challenging sector returns, some institutional investors are questioning what the role of natural resources should be in a portfolio and if now is a good time to invest in the asset class.

At Commonfund, we continue to believe in the strategic role of natural resources and the three core reasons for inclusion in a well-diversified portfolio:

  • Growth and potential for alpha generation

  • Diversification

  • Inflation hedging potential

Let’s take a closer look at each attribute.

Growth and alpha exposure to essential commodities

While it is possible to directly invest in commodities via futures contracts, investing in operating businesses (public or private equity) that focus on commodity-related areas (e.g. oil and gas producers like Shell, oilfield service companies like Baker Hughes or mining companies like Rio Tinto) can offer similar exposure, but with the potential for realizing operating leverage, earning the equity risk premium and in the case of private investments, an additional illiquidity premium. In contrast, while investing directly in commodity futures offers investors explicit exposure to macro supply and demand dynamics, marginally higher correlation to inflation and lower correlations to other asset classes they come with lower return expectations due to the lack of inherent cash flow and growth associated with owning the commodity future (outside of potential positive price movements). Further, negative roll yields associated with futures markets in contango1 can lead to negative returns in flat commodity price environments. Alternatively, public or private companies can generate positive cash flows in flat price environments. This is a critical consideration for long term investors with real return objectives of approximately 5 percent.

Additionally, natural resource inputs underlie many facets of the economy. These inputs come in many forms: oil inputs in transportation, natural gas inputs in electricity, and metals and mining inputs in manufacturing, infrastructure and technology, for example. While each individual commodity experiences its own volatility based upon their respective supply and demand curves, there are opportunities to generate attractive relative returns by targeting higher growth and/or lower marginal cost investment opportunities, which can be resilient regardless of the point in the cycle and offer greater return potential.

Diversification

Natural resource related assets have historically shown positive diversification benefits relative to traditional asset classes. As shown in the below chart, we compare the quarterly and rolling 5 year returns of the S&P Small Cap Energy index relative to common asset class indices. Both data series indicate strong diversification properties particularly versus a traditional S&P 500 and Bloomberg Barclays US Aggregate Bond portfolio with rolling 5 year correlations close to zero.

CH1-CorrS&PSmCap

Inflation hedging potential

Natural resource related assets have historically shown a positive relationship with inflation. In the chart below, we show correlations relative to the Consumer Price Index (“CPI”) to indicate how well a particular asset class might historically perform relative to inflation. While there are no pure hedges to inflation (i.e. correlation of 1), natural resources, as represented by the S&P Small Cap Energy Index, have exhibited a higher correlation relative to other asset classes. While pure commodities have historically demonstrated an even higher correlation, this comes at a cost to long term returns.

CH2-CorrCPI

Tactical considerations

While we counsel long term strategic allocations to the sector, recent relative underperformance has driven the natural resource sectors market weights well below their longer term average. This potentially increases the risk to traditional portfolios to an inflationary environment as the sectors with the highest positive correlation to CPI have been reduced. Additionally, we show the price multiples for the broad S&P 500 index and the S&P 500 Energy and Metal & Mining sectors indicating pricing may present a good relative entry point.

CH3-SP500

The combination of these three attributes – growth and potential alpha generation, diversification and inflation hedging – offers natural resources a unique role within a portfolio. While natural resources businesses can exhibit inherent volatility with the pricing fluctuations of the underlying commodities, in our experience it is exceedingly difficult to exactly time these cycles. Some years will always perform better than others. But, if an investor stays consistent in allocating a portion of the portfolio to the space with a bias towards advantaged producers and service providers, one can not only expose the portfolio to these cycles, but potentially take advantage of them.

1Contango occurs when the current futures price of an asset (as quoted in the futures market) is higher than the current spot price of the underlying asset.

Authors

X
Ethan Levine is co-Head of Real Assets and Sustainability and a member of the Investment Committee of Commonfund Capital. His primary responsibilities include due diligence, manager selection and portfolio construction for the firm’s natural resources programs while also contributing to venture capital, private equity and distressed capital programs. Ethan originally joined Commonfund Capital in 2007 as a Senior Analyst in the Commonfund Capital Rotational Program. Prior to Commonfund Capital, Ethan specialized in energy markets at Charles River Associates, an economic and litigation consulting firm in Boston, MA. At Charles River Associates, he advised power and utility clients with their damages litigation, regulatory approval and business strategy forecasting. While at business school, Ethan also worked at Rockland Capital, a private equity firm, where he conducted due diligence on potential power generation asset acquisitions and helped manage existing portfolio investments. Ethan is a member of the advisory boards of several private capital limited partnerships. He is a member and prior chairperson of the Dartmouth College Hillel Board of Overseers. Ethan received a B.A., B.E. and an M.E.M. from Dartmouth College and an M.B.A. from the University of Chicago Booth School of Business.
Ethan J. Levine
Managing Director
X
Paul Von Steenburg is a member of the Commonfund Asset Management Investment team and is primarily responsible for asset allocation, manager sourcing, due diligence, and investment monitoring for investment portfolios with a focus in real asset strategies and private real estate investments. He serves as a member of the Commonfund Asset Management Investment Committee. Paul also serves on advisory boards of the firm’s investment managers. Prior to joining Commonfund, Paul was a Vice President in the consulting division of Wilshire Associates, where he advised institutional investors. Paul was also the Chair of Wilshire’s Hedge Fund Committee, where he was responsible for conducting research and providing advice on the selection of hedge fund managers. Prior to Wilshire, Paul worked in equity research for Waddell & Reed Asset Management. He also spent five years with the Instinet Group as Manager of the Global Correspondent Trading Group. Paul earned a M.B.A in Finance from Cornell SC Johnson College of Business and a B.S. from Rutgers University. Paul also holds the Chartered Financial Analyst and Chartered Alternative Investment Analyst designations.
Paul Von Steenburg
Managing Director, CFA, CAIA

Subscribe & Manage Your Frequency to Insights Blog

Stay up-to-date with the latest information with our Insights Blog. Topics covered included:

  • Asset allocation

  • Governance and policy

  • Industry knowledge

  • Market commentary

  • Outsourced investing

  • Risk management

  • Responsible investing

Sign up now to stay informed.

Already signed up? Change your subscription frequency here.



Fill in your details below


Notification Frequency


Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.