Typically, they don’t have large specific allocations to resource equities, and the broad market indices don’t provide much exposure to the commodity producers. The S&P 500’s exposure to energy and metals companies has dropped by more than 50% over the last few years, and the same is true of the MSCI All Country World Index. Those investing with a value bias may be particularly underexposed to resource equities, as value managers tend to be especially averse to the risks posed by commodity investing.
Jeremy has written extensively about the long-term prospects for natural resources, but there are advantages to commodity investing beyond potential commodity price appreciation, including diversification and inflation protection. Resource equities are a great way to gain commodity exposure while also accessing the equity risk premium. Given their somewhat hybrid nature, with one foot in the equity market and the other foot in the commodity market, resource equities display some unusual characteristics; over various time frames, resource equities may move more with equities or more with commodities and can look more or less risky than the broad market. Perhaps due to their quirky nature, resource equities are generally unloved and possibly misunderstood. However, we believe that resource equities present a compelling investment opportunity, both strategically and tactically, and that long-term investors could benefit from larger allocations to these assets.
Why Access Commodity Exposure via the Public Equity Market?
The equity risk premium is critical.
The equity risk premium is the main reason for preferring the equity markets to other means of gaining commodity exposure. While oil prices have risen just slightly in real terms since the 1920s, oil and gas companies have generated real returns of more than 8% per year. That’s a pretty healthy equity risk premium. The industrial metal miners have similarly outperformed the underlying metals. The public equity market has clearly been far superior to direct commodity investment historically. That’s not even considering the storage and transportation costs, perishability issues, etc., associated with direct commodity investment.
The problem with commodity futures
Many investors look to the futures market for their commodity exposure. However, futures investors contend with the futures roll yield when they sell out of an expiring contract and roll into a longer-dated contract. When futures curves are in contango or upward sloping, there’s a drag associated with selling out cheaper near-term contracts and buying the more expensive longer-dated contracts. “Sell low, buy high” is generally not a sound investment practice, and it turns out it hasn’t worked out well for investors in the commodity futures market over the past decade or so. Since 2000, commodities, as represented by the Bloomberg Commodity Spot Index, have gone up by almost 200%. However, this is a theoretical return reflecting the return you would have received if you could have bought commodities at spot prices without incurring the costs of dealing with the physical commodities. The investable index, the Bloomberg Commodity Index, covers the same basket of commodities and is implemented via the futures market.
Additional benefits to equities
The equity risk premium and futures roll yield are the two main factors that push us toward equities, but there are other additional benefits to equities. Public equities tend to be liquid and cheap to trade, and the public equity market offers a diverse set of business models that offer exposure to natural resources. Furthermore, the ability to value and select stocks within resource equities can yield additional returns.
What about private equity?
Private equity shares many of its public brethren benefits and seems like a reasonable alternative if you like fees and illiquidity…, but we don’t! Complicating matters, all privates are not created equal; it can be difficult and time-consuming to identify the few private equity managers who really add value. Often, the good ones are closed to new investments. Locking capital up at high fees with managers who generally don’t add real value gives us pause, especially given the transparency issues involved with private investment.