Go global and create your own resources boom

For many years, alternative investments such as long short funds were only available to institutional investors and high-net-worth individuals. In recent years, however, the inclusion of long short funds on investment platforms has opened up the industry to a wider range of potential investors.

Indeed, funds that are available on the major platforms are normally open to investors with only a small initial investment or those who wish to make modest regular contributions. Attracted by the favourable risk-adjusted returns that long short funds aim to generate, some advisers are now recommending their clients allocate a portion of their assets into the long short fund space.

Long short funds appeal to investors as they can offer the opportunity for high absolute returns and seek lower levels of volatility than long-only funds. The risk-adjusted returns from long short funds can therefore be superior to those from long-only vehicles.

The ability of long short funds to implement covered short positions helps to offset risk from long exposures and additional alpha can be captured from underperforming shorts. In a nutshell, covered short positions can be used to adjust the net exposure of a portfolio, although most long short funds tend to maintain a net long bias.

Recent share market conditions have reminded people of the risks that can be involved in equities investing and it is unsurprising that products that aim to reduce market volatility are appealing to investors.

Some long short funds are very specific in nature, and focus investment in one niche area. Others are much broader and can provide investors with exposure to a range of opportunities in different asset classes, investment strategies, geographic regions and industry sectors.

One area of long short fund investing with which some investors may be unfamiliar is in the global resources sector. A number of funds that operate in this space seek to generate strong absolute returns by investing in resources companies and generally hold both long and covered short positions.

The resources sector is vast and comprises companies involved in the exploration, development, extraction, processing and transportation of natural resources including oil and gas, base and precious metals, bulk commodities, precious stones, industrial minerals, forestry, pulp and paper products, and renewable resources including water and alternative energy sources. Companies that provide services to these industries are also included in the investment universe.

Notwithstanding the cyclicality in commodity prices that characterises the sector, the long-term supply/demand for raw materials remains favourable. The industrialisation of countries such as China and India should continue to provide strong demand for materials.

While the pace of growth in these regions has certainly slowed of late, the longer-term growth potential for emerging economies remains in little doubt. Put simply, growth in emerging regions requires raw materials, and a great deal of them.

This may be particularly relevant for investors as statistical analysis suggests there may be substantial benefits in including an allocation to global resources in the asset mix.

Not only have resource equities delivered favourable returns relative to some other asset classes over the long term, they also have different return characteristics and a low correlation to other recognised asset classes.

As a consequence, the asset class is popular with investors seeking additional diversification in their portfolio.

Many Australian investors are comfortable holding some resource exposure in their portfolios by investing in large cap, domestically-listed diversified resource companies such as BHP Billiton and Rio Tinto.

It is worth noting, however, that Australian listed companies account for only 18 per cent of the HSBC Global Mining Index by capitalisation and only 2 per cent of the MSCI World Energy Index (as at December 31, 2008).

A global approach to investing in this asset class therefore provides greater flexibility, enabling investors to obtain exposure to truly world-class companies and can further diversify the investment mix by commodity type.

Our approach is to seek high absolute returns by exploiting mispriced opportunities across the whole resources equities spectrum. We manage from a ‘bottom-up’ perspective, where the quality of a company’s underlying asset base, rather than a short-term commodity price view, is key to the investment decision.

Our view is that bottom-up stock selection is superior to the imprecise and extremely difficult ‘top-down’ approach of trying to predict fluctuating commodity prices and forecasting macroeconomic trends and other commodity price demand drivers.

We believe that successful investing in the sector requires a thorough technical understanding of the underlying industries in which listed resources companies operate.

Our specialist resources team combines rigorous financial skills with extensive technical knowledge, like geology or metallurgy.

As bottom-up stock pickers, it is vital to have firsthand knowledge of companies’ operations and we therefore spend considerable time on site visits, meeting key technical people, discussing their methods and reviewing geotechnical data. We typically complete more than 70 site visits each year as well as making hundreds of company contacts.

The information that can be obtained from seeing a company’s operations on the ground (and, often, under the ground) can be so much more valuable than poring over financial statements in the office.

David Whitten is head of global resources at Colonial First State. Portfolio manager John Ellis and senior portfolio manager Chris Baker also contributed to this article.