There is an old adage: 'Invest in what the world wants'. The world certainly wanted commodities in 2009, resulting in significant price rises, well in excess of 100% for some commodities, and with demand for raw materials remaining high, prices are continuing to rise in 2010. The question is: Are we in the middle or at the end of a commodities bull run and should charities be investing in the sector?

Commodities are generally divided into four categories: soft commodities, mainly agricultural, such as wheat, sugar, palm oil and coffee; industrials or base metals, including copper, nickel, lead and zinc; precious metals such as gold, silver, platinum and palladium; and energy, primarily oil, coal and gas.

Across that range, 2009 saw the biggest annual price increase in raw materials for nearly four decades, with indices gaining more than at any time since the 1973 oil crisis.

The Dow Jones-UBS Commodity Index, which is based on 19 futures contracts spread across the commodities range, saw a 19.45% rise in 2009, with other individual Dow Jones-UBS commodity indices recording significant rises: Copper 128.92%; Zinc 93.1%; sugar 88.1%; and Nickel 55.71%. However, some indices were in negative territory, with Natural Gas the worst performer at -47.85%, but even that was on the turn recording a 20.6% rise in December alone.

In January the IMF said it expected commodity prices to remain high by historical standards over the long term, with the Fund's economists predicting an expansion in global activity would put upward pressure on commodity prices.

In the investment arena, fund managers believe the positive fundamentals will continue to affect the commodities markets, with renowned investor Jim Rogers predicting there will be close to a two-decade under supply of raw materials and a consequent boom for commodity prices.

Fundamental drivers
So what are those fundamentals?
The key driver, according to the IMF, and backed up by investment managers, is the expansion of demand in emerging markets.

The continuing growth in the more dynamic emerging market economies - such as the BRIC economies of Brazil, Russia, India and China - is increasing demand for commodities as these countries undertake large infrastructure projects, as urbanisation takes place, and as their populations aspire to higher standards of living.

Alongside this major influence, there are the effects of quantitative easing; the restocking of resources inventories as the global economy begins to show stronger signs of recovery; the flight to gold as 'real asset'; and the weakness of the dollar as the world's reserve currency.

Add to that list restrictions in supply of many commodities and you have a strong, if simplistic, argument that commodities prices will continue to rise.

Soft commodities
Taking a look at the commodities most favoured by investment managers, agriculture commodities, in particular, are seen as having strong potential. This is partly a play on the emerging markets growth theme and partly because falling prices in the past 18 months mean they are cheap at present.

Jeremy Charlesworth, head of the Moonraker Commodities fund of hedge funds, believes agricultural commodities will be among the most significant in the years ahead, as emerging market populations begin to enjoy better diets, consuming more meat, which in turn requires more grain to feed cattle. At the same time, he says, a growing scarcity of agricultural land available to increase production and a shortage of water in key areas, will result in higher prices for soft commodities.

Wayne English, commodities fund selection specialist with Collins Stewart Wealth Management, is equally bullish, based on the demand story from emerging markets. "But you have to be active in the space," he adds. "Using tracker funds could leave you with too high an exposure to volatile commodities.

"Farmers plant the crops where they can see the highest price. This floods
the market, prices drop and they change to a different crop. The emerging markets make agriculture a good long-term play but investors must expect volatility in the short term and they need an active fund manager to deal
with that."

Precious metals
Gold is the precious metal which nearly all fund managers flag as a strong long-term investment. This derives mainly from its role as an alternative to depreciating currencies, weakened by the effects of quantitative easing. The Reserve Bank of India recently bought gold from IMF's reserves to diversify its foreign exchange away from US dollars.

Gold's stability and capacity to rise in price can also be put down to the fact it does not deteriorate so the total world's supply is actually quantifiable; it is increasingly difficult to extract in large amounts - in particular in South Africa, the largest provider of gold to the market; and it can be both traded and held as a physical asset.

Holding gold in a portfolio as a physical asset is an option that fund managers and investment consultants currently favour, although there are insurance and storage costs to consider.

Energy space
Jonathan Blake, investment manager of the Barings Global Resources fund, sees considerable investment potential in the energy space. "If you look to where new sources of energy supply are coming from it is either deeper waters or harsher environments or alternative areas such as oil sands - all of which needs higher prices to make extraction viable."

Add to that a lack of investment by oil companies in the past two years into infrastructure and drilling, and the fact, as Oliver Burns, director private clients and charities, at Jupiter Asset Management, points out, that production, while still healthy, is peaking and on a downward trend, "means increasingly oil will only be extracted if it is economic to do so," he says. That will start to push up prices.

Industrials
Collins Stewart's English points to the large demand from China for base metals as a key underlier for the prices rises seen in 2009. "China was stockpiling early in 2009 because commodity prices were so low and to carry out the infrastructure development going on in the country - this had an effect of raising prices," he says.

Whether those prices can be maintained will depend on what English terms "final demand" coming through from different areas of the world, as other users beginning to replenish their inventories. "But we will really need the global recovery to fully kick in before we see that," he adds.

Words of warning
While the fundamentals look good, fund managers do offer words of warning to investors. Set against the positive trends is the potential for a rally in the US$.

As most commodities are priced in dollars, they tend to have an inverse relationship with the currency. A strengthening of the dollar, therefore, would act against the commodity markets. Jupiter's Burns, for one, believes the dollar will strengthen in 2010. "It has been substantially sold off and at the moment it is looking cheap," he says.

Other significant threats, says Barings' Blake, is a disappointment in terms of the recovery and the "policy risk" as quantitative easing is withdrawn. "There is no doubt that the liquidity being pumped into financial markets has affected commodity prices and how that liquidity is withdrawn will be crucial to how markets respond," he says.

As ever, the lynch pin will be the US economy, and in 2010 its ability to step further out of recession and increase its domestic consumption. "The main indicators are pointing to the beginnings of a global economic recovery - a trend which has been pre-empted by the commodity and the equity markets - so we need to see the recovery continue," Blake says.

There are thoughts too that China and other buyers of commodities, may have sufficiently restocked their inventories, given that western demand for China's exports has weakened, which means Asia's powerhouse economy will not undertake the same level of resource buying as in recent years.

However, it is short term volatility in the commodities markets that is seen as the predominant threat to investors. "In 2008 we saw huge volatility in commodity prices and demand fell off a cliff," says Jupiter's Burns. "While we are fairly bullish on most commodities on the basis that demand is tending to be strong and will continue to be so, it is a volatile asset class and we could easily see sell offs."

Yet, despite the potential threats, the consensus view of fund managers remains that the bull run still has a way to go and for investors with long-term investment horizons commodities should be an active play.

As Nigel Cuming, chief investment officer at Collins Stewart Wealth Management, sums up: "I believe we are in the middle of a longer term bull market but with the volatility in the commodities sector you have to be very careful. You need an active manager to play the space. Charities should have investments in commodities if they buy into the Asia/emerging markets story, but they should leave the management to specialist funds."

Commodities and ETFs

Guy Davies looks at how ETFS can be successfully used by charities to access the commodities universe

Charities in the UK have long had an uneasy relationship with commodities. The Charity Commission is clear about what it regards as a permitted investment or not. Commodities in themselves are not a permitted investment if there is not an 'investee' and there is no 'investment'.

If a charity simply purchases a commodity, such as gold, fine wine or art, in the speculative hope that they will eventually be able to obtain a higher price from a purchaser than they have paid, or where the trustees are, in substance merely gambling with the charity's funds, this will be usually regarded as a trade.

As a result, the charity will be penalised and suffer a higher rate of tax on the gain.

A charity is permitted to invest into commodities through the use of a commodity fund, as there is deemed to be an investee and the fund is by its nature an investment.

Modern portfolio
In recent years many charities were persuaded to buy into a range of alternative investments as part of what became 'modern portfolio theory'. The theory stated that if an investor spread their investment portfolio across a diverse range of assets, the assets would perform in different ways. In some cases, these were actively marketed and offered apparently much higher returns than conventional share portfolios.

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