Two Keys to Commodities Investing: Avoid the Indexes and Seek Active Managers.

Of the more traditional commodities, Pimco’s Nicholas Johnson is most upbeat on oil.

Andrey Rudakov/Bloomberg

Investing in commodities requires an active approach. For starters, the two major commodities indexes differ considerably. The S&P GSCI Commodity Index has about 50% in energy; the Bloomberg Commodity Index is one-third energy, one-third metals, and the rest in other commodities.

Neither index has enough in some of the commodities with the most promise. “Lithium, copper, tin—all of these electrification metals are going to have a big demand surge over coming years. These are not common in the indexes, but a good active commodities manager can trade off-benchmark, like Pimco,” says Bobby Blue, a senior manager research analyst at Morningstar. “These metals are underinvested, and [active funds] give you the ability to get exposure. If you want to make a bullish bet on these industrial metals, the commodities index isn’t the way.”

Finding an actively managed fund isn’t as easy as it seems. Most of the commodity-oriented mutual funds tracked by Morningstar are quantitative—they use computer models to find, for example, the best trades based on how futures contracts are priced, and to exploit arbitrage opportunities between different duration futures contracts. Active managers can better spot opportunities based on macro trends and fundamental assessments, and better take advantage of the “tremendous opportunities” in industrial metals and carbon markets, Blue says.

One of Blue’s favorites is also one of the largest—the $7 billion Pimco CommodityRealReturn Strategy (ticker: PCRAX). The fund has an average annual return of nearly 14% over the past three years, beating 91% of its peers, according to Morningstar. The fund’s managers, headed by Nicholas Johnson, look for relative value within commodities futures to generate better-than-index returns.

Johnson is focused on commodities that will benefit as the world tries to decarbonize. Lithium and cobalt are needed for these processes, but they aren’t that liquid. Instead, Johnson says he is investing more in carbon markets created by cap-and-trade programs in California and Europe. Cap-and-trade programs limit, or cap, how much carbon dioxide a company can emit. Those that exceed the threshold have to purchase extra permits from companies that pollute less. The caps are expected to drop as nations move closer to their carbon-neutral goals, which will reduce the supply of carbon permits and drive up prices. Johnson says interest in these carbon markets is increasing, and posits that carbon futures will be included in the main commodities indexes. “If you believe the energy transition is ongoing, then it’s a bullish case for carbon,” Johnson adds.

Best in Class

These actively managed funds are better positioned to take advantage of the three big trends driving certain commodities.

Fund / Ticker AUM (mil) 1-Yr Return 3-Yr Return 5-Yr Return Expense Ratio* Comment
Pimco CommodityRealReturn Strategy / PCRAX $7,000 33.4% 13.8% 5.9% 1.27% Largest active fund, beat 88% of peers over past 3 years; invests beyond index, including in carbon markets
Columbia Commodity Strategy / CCSAX 507 32.8 11.5 4.3 1.13 Below average expense ratio; lead manager shifting away from industrial metals and natural gas, toward corn in near term
BlackRock Commodity Strategies / BCSAX 1,600 22.1 12.8 6.0 0.97 Low expense ratio; not pure commodities; half is invested in stocks like Chevron, Glencore, and BHP

*All funds charge a load. Three- and five-year returns are annualized.

Source: MorningstarDirect

Of the more traditional commodities, Johnson is most upbeat on oil. While he says prices are high after the run-up in 2021, he expects them to be about where they are now—but that still is an attractive investment opportunity because of the roll yield. One risk he’s monitoring: the possibility that inflation crimps demand and sends oil prices down and bond yields much higher.

The managers of the $507 million Columbia Commodity Strategy fund (CCSAX) look to capitalize on supply-and-demand imbalances across commodities, as well as structural inefficiencies in its benchmark. That helped the fund return 33% in the past year, beating more than two-thirds of its Morningstar peers.

The fund differs from its benchmark index in where it invests on the futures curve. The index is primarily filled with commodities contracts on the front end of the curve, which are subject to more volatility; bad weather can lead to price swings in agriculture futures, for instance. Instead, the managers look for longer-term futures contracts—three or six months out—where suppliers typically go to hedge their exposure to more-erratic short-term contracts. “The back end is not only mispriced because of the hedging pressures; they also are less volatile,” says Marc Khalamayzer, lead manager of the fund.

Over the past year, the fund also invested some of the collateral it holds for the futures contracts it invests in, putting some of it in ultrashort, low-duration commercial paper—rather than just T-bills— to generate some extra return.

Khalamayzer has been selling natural-gas holdings as supply recovers, and allocating more money to agricultural commodities like corn as fertilizer prices hit highs. “It’s going to be an input cost into growing agriculture,” he says. “And separately, energy is needed as an input to collect crops at a time food demand is still relatively high.”

Khalamayzer is less optimistic in the near term for most industrial metals, largely because of China’s efforts to reign in its property sector and refocus resources elsewhere—a sign that for the foreseeable future, the sector, even if it doesn’t contract, is unlikely to be the engine of growth it was in the past. Omicron poses a risk more broadly to commodities, especially if the lockdowns emerging in Europe spread more widely, but Khalamayzer says he would look to add during any bouts of volatility.

The $1.5 billion BlackRock Commodity Strategies (BCSAX) is a bit of a middle ground; it splits its allocation equally between the two options. That approach means it lagged behind purer peers last year with a return of just 22%, but that balance helped over the longer term. The fund’s average 12.8% return over the past three years beat 71% of its peers, according to Morningstar.

While the forces driving this commodities boom look different than the last one, one thing that hasn’t changed is the volatility of the asset class. If anything, that volatility could be amplified, as commodities sit in the center of three momentous shifts—fluctuating inflation expectations, a changing China, and an energy transition that has already proved to be bumpy. That’s why asset allocators are still caution that it should be just a fraction—5% to 10%—of portfolios.

Write to Reshma Kapadia at reshma.kapadia@barrons.com