July 31, 2012 / 8:18 AM / 8 years ago

REFILE-Commodity niches lure as markets converge

* Main commodity indices increasingly track other markets

* Investors seeking diversification look at sub-sectors

* Niche areas more isolated from marco events

* Real assets, OTC energy products, agriculture targeted

By Eric Onstad

LONDON, July 31 (Reuters) - As commodity indices increasingly track other markets, investors are targeting niches including timber and other real assets, over the counter (OTC) energy products as well as agriculture markets with more insulation from macro-economic events.

When investors piled into commodity markets a decade ago, one of the main attractions were their diversification qualities: here was a sector that did not move in line with equity, bond and foreign exchange markets.

But since the 2008 financial crisis, broad commodity indices have shown much stronger correlation with other markets, especially risky assets such as equities, providing less diversification for institutional investors.

A quarter of investors who cut exposure to commodities said the reason was high correlation with other assets, according to a survey by Barclays earlier this year.

Some investors are honing the focus of their cash on real assets including farmland, timber, mines and energy projects, which are less correlated to financial markets.

“When we talk to our investors, they talk about the arguments about the benefits of real assets,” said Daniel Leveau, head of portfolio management of 1741 Asset Management.

The Zurich-based group, which has 1.8 billion euros under management, is a subsidiary of Notenstein Private Bank, in turn owned by Raiffeisen Cooperative Switzerland, the country’s third largest banking group.

“We’ve seen a lot of demand from private clients who are trying to protect their private wealth and also on the institutional side, demand for exposure to an underlying asset which is tangible.”

The move to real assets and other alternative commodity investments has occurred as investors withdraw money from commodity index products with exposure to commodity markets.

Commodity index swaps have suffered $6.5 billion of outflows so far this year, Barclays said earlier this month, after five consecutive quarters of outflows.

Simon Fox, a London-based principal at Mercer, which advises pension funds on their investments, said he recommends exposure to commodities through real assets rather than index products.

Some 2.3 percent of UK pension funds surveyed by Mercer this year have exposure to commodity or timber assets, more than double the percentage in 2008, when it was less than 1 percent.

This expected to climb further in coming years as pension funds diversify their portfolios away from equities, Fox said. Mercer advises 873 clients with 671 billion pounds of assets under management.

NICHE ENERGY PRODUCTS

Another way to avoid investing in products that move along with other risky assets is through OTC energy markets, said Guy Wolf, macro strategist at brokerage Marex Spectron.

“If you are looking for alpha in the commodity world, there are really only two places you can go. One is the OTC energy space and the other is agricultural futures.”

Alpha measures the risk-adjusted return of an investment or the return in excess of a benchmark index.

One reason financial markets have become so interlinked is through computer trading programmes, but the black boxes are not able to access many niche OTC energy markets, Wolf said.

So far there have been only tentative moves into these markets by asset managers, some of which are restricted to investing in listed markets, he added.

“Attitudes are changing, however, as funds are always looking for non-correlated liquidity pools. We are doing a lot of work with some very large funds to research these markets and provide liquidity analysis as well as execution infrastructure.”

The UK and European gas and power markets will probably be the first OTC energy markets to attract fund money, Wolf said.

“Assuming you know the fundamentals, you can potentially make money in pockets of OTC markets where you can be relatively isolated from whether a Spanish bank needs more capital. I think people will seek them out a lot more than they have done.”

AGRICULTURE, GOLD

Within traditional futures markets, agricultural products are jolted by droughts and floods, often swimming against the tide of macro events that sway commodities and other markets.

“Agriculture still has nice diversification compared to equities, so that will remain a nice diversifier,” said Koen Straetmans senior strategist at ING Investment Management in the Netherlands, which has 330 billion euros under management.

During the 10 years before 2008, the average correlation between the S&P GSCI commodity index and the S&P 500 equities index was close to zero, but during the past three years it has soared to 70 percent.

The 30-day correlation of the Goldman Sachs agriculture index to the S&P 500, however, is at 20 percent.

Since the beginning of May the GSCI agriculture index has gained 16 percent as a drought damaged crops in the U.S. Midwest while the main GSCI commodity index shed 7 percent, weighed down by worries about the euro zone and global growth.

At Armajaro Asset Management in London, the firm’s flagship Commodities Fund has seen redemptions this year, but there has been renewed interest in the group’s CC+ fund, which focuses on cocoa, coffee and other agricultural markets.

The CC+ fund which has had average annual returns of 12.4 percent since launch in 2007, has attracted interest mainly due to its lack of correlation to other financial markets, Chief Executive Harry Morley told Reuters earlier this year.

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