As food prices rise, investors should consider systemic impacts of their commodities strategies.

What do bushels of oats, live hogs, platinum and crude oil have in common? An investor might answer that commodities such as these increase risk-adjusted returns and portfolio diversification. Over the past decade, institutional and retail investments in commodities have ballooned from roughly $10 to $400 billion, and could easily double in the coming years. Many investors will be aware of the long-term trends creating risks and opportunities in commodity investment. Resource scarcity and a demographic wave of new consumers will apply upward pressure on prices, while greater end-use efficiency and new recycling techniques will mitigate this effect. At the same time, the risk of governments introducing trade barriers or new regulation looms over markets. To successfully navigate this landscape, long-term investors should consider the “systemic” effects of rapidly growing institutional investment in commodities and the unique ESG issues raised by their activities across different areas of commodity investments. Most financial investors gain exposure to commodities through derivatives. Typically, investors take net long futures positions, which are implemented by index tracking funds, hedge funds and other vehicles. For derivatives investors, the notion of responsibility arises primarily through their potential influence on commodity prices. While derivatives investors do not have a long-term directional impact on spot markets, research shows that they can contribute to short-term price movements by amplifying fundamental trends and influencing the behaviour of commercial actors. This can result in excessive volatility, turning derivatives markets from an important source of stability into a source of uncertainty for the real economy. Particularly for certain agricultural commodities, large price fluctuations can threaten not only profits but lives.Available studies use data from recent years (when investment levels were considerably lower) and generally conclude that financial investors have thus far exerted only a small influence on commodity prices. Past observations, however, are not necessarily indicative of the future. The impact of derivatives investors will increase in the future. As more participants enter the market and the ever-increasing range of exchange traded funds makes it easier to invest, momentum investing strategies will increase price volatility. Investors will also look to expand to less-liquid peripheral commodity markets where a higher impact on prices can be expected, as the contango effect has eroded index-investing returns in mainstream markets.
In a recently published report Link we propose a range of possible actions for responsible investors wanting to minimise their potential influence on commodity prices, including:
• Focus on strategic, passively implemented portfolio allocations to commodities with frequent rebalancing. This has the effect that the investor is a seller of futures when prices go up (and vice-versa) which tends to stabilise prices.
• For active managers, define reasonable performance targets and forbid taking physical delivery.
• Avoid those agricultural markets where price volatility has a disproportionate effect on vulnerable populations, and also avoid small, illiquid markets where the likelihood of influencing prices is particularly high.

Investors wishing to go further could work with exchanges and other market participants to develop futures contracts that stipulate a minimum ESG standard in the production of the underlying commodity. In contrast to derivatives, investors in physically-backed investment products take responsibility for the ESG

issues related to the production (and delivery) of that commodity. Previously limited to precious metals, these investments have now expanded to industrial metals, such as copper, nickel and tin. More products for a wider range of metals will follow. ESG issues related to commodity production vary based on the commodity and the location of its production, ranging from toxic tailings at a gold mine in Canada to labour conditions on a sugar plantation in Brazil. Due to the standardized nature of commodities, it is difficult or impossible to distinguish between origins and to engage with producers. This is a problem for any responsible investor. Furthermore, by buying and holding physical commodities, sometime in significant quantities, financial investors remove these resources from the real economy. Such activity undermines their credibility as long-term oriented actors. Considered on a systemic level, hoarding commodities could also depress growth and equity returns, potentially creating a zero-sum game for investors. To minimise negative effects we propose the following guidelines:
• Only invest in physical commodities where competition with industry is negligible.
• Support initiatives to develop ESG standards for the production of major commodities.
• If possible, invest with fund managers that buy commodities from traceable, ESG-certified sources.

In addition, productive assets such as farmland and mines have emerged as an increasingly attractive means for institutional investors to gain exposure to commodities. Real assets provide stable income streams and a hedge against inflation, and are owned either directly or through specialist funds.As (co-)owners, financial investors in real assets are responsible for the full range of ESG issues related to the production process, including issues around environmental management and the respect of human rights. These investors, however, have information and control over the production process, though this varies based on whether they own the asset directly or indirectly via a fund. In our report, we propose guidelines for investors in real assets, including:
• Request that operators and managers comply with existing best practice standards.
• Where these are inadequate, stimulate the development of improved ESG standards for various asset types.

Finally, public equity investors are indirectly exposed to commodities by holding companies that own productive assets (oil companies, paper and pulp companies etc.). Here, responsible investors can apply commodity-specific knowledge to integrate ESG information in their investment decision making and in their active ownership policies. The different access points to commodity investing raise different issues for long-term investors. In general, passive investments in derivatives will disrupt the real economy less than holding physical commodities. Owning productive assets allows investors to exert a high degree of control on the commodity production process, whereas public equity investors can incorporate commodity-specific knowledge in their active ownership policies.

Ivo Knoepfel is the founder of and David Imbert a consultant at onValues, a Swiss based investment consulting firm. The report ‘Responsible investment in commodities’ summarises results of a project in collaboration with the Swiss Federal Department of Foreign Affairs, the Principles for Responsible Investment secretariat, and the UN Global Compact.