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How to hold commodities in a sustainable portfolio (and why you would)

Sustainable investors often exclude commodities because of their ESG-unfriendly reputation. But there are ways to hold them sustainably, argues ALAN POLLEY

  • Commodities play an important diversification role
  • Commodities can be consistent with ESG
  • Find out more about Pendal’s multi-asset funds

INVESTORS who exclude commodities from sustainable portfolios are missing out on an important source of diversification, argues Pendal PM Alan Polley.

Commodities — typically metals, energy or agriculture materials — are highly correlated with inflation and can hedge geopolitical and environmental risks, making them an important part of a balanced portfolio.

But many are inconsistent with ESG principles. A nuanced approach may be necessary to screen out unsustainable holdings while still including those that are consistent with the low-carbon energy transition.

“A sustainable portfolio needs to have diversification just as much as a non-sustainable portfolio — so it’s important to think about non-traditional asset classes,” says Polley, a portfolio manager with Pendal’s multi-asset team.

“We hold commodities in our sustainable multi-asset funds and have done for quite some time.”

Inflation hedge

Commodities tend to be highly correlated with inflation and have a return distribution with a positive skew, meaning returns on the upside tend to be bigger than returns on the downside.

“That’s because commodities are sensitive to supply shocks which can cause the prices to shoot up. That can be useful to hedge geopolitical and environmental risks.”

These features are particularly useful in the current market.

“We think inflation is going to be higher than in the past. We think there’s going to be more inflation spikes. We also think geopolitical and weather-related risk is going to be higher,” says Polley.

“That suggests commodities have more of a role to play in a balanced portfolio going forward than they had in the past last decade or two.”

The problem for sustainable investors is that many commodities look questionable through an ESG lens.

“If you’re a sustainable investor, you can’t just go and invest in all the commodities that make up the standard commodity indexes — energy, base and precious metals, agriculture, livestock.

“That leaves sustainable portfolios not being as broadly diversified as they should be.”

Positive screening

So, how can commodities be included in a sustainable portfolio?

Polley says investors should not only screen out commodities that do not meet ESG criteria, but also actively seek out commodities that do support ESG goals.

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“In terms of negative screening, we don’t want to invest in commodities that are inconsistent with the transition to a low carbon economy. In practice that means we won’t invest in fossil fuel-related commodities in our sustainable funds.

“We also screen animal welfare issues. Livestock is not consistent with the ethics of sustainable investing. In addition, cattle is highly carbon emissions intensive.”

But plenty of commodities are consistent with sustainable investing, he says.

“There are two considerations to be balanced — the utility of a particular commodity in terms of helping to transition to a low-carbon economy versus the externalities like the carbon-emission intensity of production.

“There’s no right or wrong answer, but they do need to be considered and balanced.”

Polley says three considerations are important:

1. Demand tailwinds

The first factor to be considered is whether there is a demand tailwind for the commodity.

“The world needs to transition to a low carbon economy and there’s some commodities that have a positive demand tailwind to that transition. We want to include those future facing commodities.

“Good examples are copper and nickel, which are critical to the to the energy transition.”

2. Hedging factor bias

The second consideration is finding commodities that can complement the factor biases in screened equity portfolios.

“Sustainable equity funds often screen out fossil fuels — and there’s not a whole lot you can do about that within your equities portfolio.

“But within your commodities portfolio, you can hedge some of those factor biases. Underweight oil stocks can be hedged by taking an exposure to commodities that have a positive correlation to energy like corn and sugar beets, which are two of the main feedstocks into biofuels.”

An underweight equities position in the materials sector can be similarly hedged by exposure to the industrial metals complex.

“We want to try and hedge those equity screens induced factor biases, as well as bias towards those critical minerals consistent with the transition to a low carbon economy.”

3. Protection from climate change

A third factor to consider is how to use commodities to protect a portfolio from the effects of climate change like higher temperatures and increased weather volatility.

“If we believe we’ll have heightened weather volatility, that will affect agricultural supply, so it makes sense to own a basket of agricultural commodities — wheat, soy bean, corn, etc.

“We already have warnings of a potential El Nino later this year.”

Nuanced approach

Investors should avoid simplistic, binary thinking about commodities and instead take a more nuanced approach, argues Polley.

“Many just buy the broad commodity index which has all the fossil fuels and livestock and is not consistent with ESG. Others think ‘commodities is mining, and mining is bad’.

“But you have to think beyond that because the world’s transition to net zero is materials and resources intensive.

“And if we don’t enhance the supply of those commodities that facilitate the green transition, then we’re just not going to transition.”

About Alan Polley and Pendal’s Multi-Asset capabilities

Alan is a portfolio manager with Pendal’s multi-asset team.

He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.

Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

Find out more about Pendal’s multi asset funds:

Contact a Pendal key account manager here

This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current at September 6, 2023.

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