Commodity fund flows to weaken in second half of 2010

LONDON/NEW YORK (Reuters) - Fund flows into commodity markets continued to rise in the first half of 2010, despite a difficult six months, but analysts are increasingly warning of a slowdown as weak returns dent investor confidence.

Money managers have piled into commodities in recent years in search of stronger returns and protection away from the troubles of equity and bond markets during the financial crisis.

But for many, the promise of diversification, hedges against inflation and any kind of correlation between rising prices and rising returns has started to ring hollow.

"We always thought it would be difficult for flow growth to match up to last year and that has been the case, but they are still strong," Barclays Capital oil analyst Amrita Sen said.

"Diversification is one the main drivers, though they are also looking for outright returns. The lack of diversification from the stock market this year is a short-term thing."

Commodity prices have tracked equity markets for the last two years as traders try to gauge the strength of the global recovery, when traditionally they have diverged with low raw material costs boosting growth and vice versa.

Barclays Capital figures show commodity assets under management (AUM) rose by $14.6 billion to $292 billion (192 billion pounds) in the first half, but the rate of growth is down on a year ago, despite expectations 2010 could be a record year for investment.

TRADITIONAL INVESMENTS

Returns and interest in traditional index investments in baskets of commodities have fallen as without a broad-based rally the cost of rolling the investments each month as contracts expire has seen losses mount.

The Reuters Jeffries basket of commodities is down 11 percent since early January, while the S&P GSCI long only commodity index has shed 7 percent.

Harry Tchilinguirian, BNP Paribas' head of commodity strategy, said the contango structure of many markets -- when the cost of future contracts are higher than current ones -- had damaged interest in traditional index investment.

"The roll comes at a cost that subtracts from the spot performance of the commodity," Tchilinguirian said.

"Under a fixed composition for the passive-long index (often reviewed once a year) there is not much flexibility in periods of market instability and high volatility."

Tchilinguirian and others said banks and funds have now developed more sophisticated index investments for clients to invest, that reweight the basket of commodities more frequently and take positions across the futures curve to try and better manage roll costs and short-term volatility.

These have proved to be more popular this year, but stronger returns than their simpler cousins have not always materialised, with Deutsche Bank's various liquid commodity indices all down between 7.5 and 10.8 percent so far this year.

Randall Dillard, who oversees several billion dollars in assets at fund of hedge funds Liongate Capital Management, said flexible indices still did not offer enough for many investors.

"While they are a big improvement on plain vanilla products that expose investors to roll fees and corrections, they still don't provide the sort of alpha clients are looking for."

HEDGE FUNDS

But for those thinking an investment in a commodity focused hedge fund could provide stronger returns in volatile, complex markets, the evidence so far in 2010 has been mixed.

Flows into the sector have been increasing according to fund managers, but data from Lipper, a Thomson Reuters company specialising in fund research, showed several Commodity Trading Adviser (CTA.L) funds shed more than 10 percent between January and May.

Of the 59 global macro funds and CTAs Lipper tracks, more than half are down for the year so far, with losses as high as 17 percent. The size of some of the losses has seen many hedge funds head for the sidelines.

"Macro funds don't seem to be that involved (in trading), CTAs are neutral to short, while the trade has battened down the hatches," brokers at MF Global said.

"The trade seems to have slowed down for the usually weaker summer season. The Europeans in particular are doing very little now."

For Saul Waksman at BarclayHedge, a provider of alternative investment performance data, the limited interest in commodities is not too surprising while the outlook for the economy remains murky, with commodity and equity markets both whipsawing back and forth on a daily basis.

"There is so much uncertainty out there about where the economy is going," Waksman said.

"We're at an inflection point where the bulls and the bears are battling it out every day. And it's brutal."

(Reporting by David Sheppard; editing by Sue Thomas)