(Kitco News) - Investment funds have dabbled in commodities for several years as prices boomed, but even more traditional-minded institutions such as pension funds are now dipping their toes in the water.

So far, these funds are allocating only a tiny portion of their portfolios to commodities, including gold. Still, this is enough money to contribute to rising prices, even if supply/demand fundamentals for some commodities, such as food items, do not always justify the rise.

This, in turn, has led to some concerns that these fund flows have the potential to disrupt pricing on some resources, such as food products.

Any decisions that funds make on natural resources as a whole have ramifications for gold, since the yellow metal is one of the commodities capturing the most attention and investment interest lately. Gold has rallied as investors look for tangible assets in uncertain economic times.

Gold has been the recipient of much attention as investors believe it has reverted back to a store of wealth, especially as it hits all-time nominal highs under concerns about fiat currencies and future inflation. But other resources are rallying, too, as investors seek to purchase commodities like agriculture on ideas that a growing global population will need to eat.

In the U.S. the biggest pension fund, the $217.5 billion California Public Employees Retirement System, known as Calpers, has invested in commodities for a few years now. It has targeted 1.5% toward commodities as part of an inflation-linked asset class, according a May 2010 investment policy, benchmarked to the S&P GSCI Total Return Index. The $134 billion California State Teachers Retirement System, known as Calsters, is looking to invest in commodities. Pension funds in the U.K., for example, have invested in gold for several years now.

Gregory Marshall, president and CEO of Global Asset Management, said it’s likely these funds are getting more questions from their clients about investing in commodities like gold as it gets more publicity. “Gold is up 20%, it’s in its 10th year of gains. Silver is up 30%. Two years ago you didn’t hear about gold on CNN or CNBC. You can’t ignore it. It’s like the pit bull that has you at the pant leg – you can’t shake free and you can’t ignore it,” Marshall said.

Keith Brainard, research director, National Association of State Retirement Association said while he can’t vouch for individual funds, interest in commodities is part of a broad movement to diversify. “Traditionally they’ve had a model of equity and fixed income, but they’ve moved to start to include private equity, hedge funds, and more recently infrastructure. Also commodities,” he said.

After the drop in most financial markets because of the credit crisis in 2008, investors of all stripes started to rethink what is meant by diversification and risk management. Very loose monetary policy globally is pushing money to seek a home everywhere, so that leads investors to think about alternative assets.

So far pension funds globally have little exposure to gold and other commodities. According to Shayne McGuire, head of global research and portfolio manager of the GBI Gold Fund for the Teacher Retirement System of Texas, a typical pension fund holds 3% of its portfolio in commodities and of that, 0.15% is in gold. Historically portfolio diversification has suggested commodities only represent a very small portion of an average plan, with 5% or less typical, so in that respect it’s hard to say that funds are flooding the market.

Yet on the other hand, considering the size of these funds, even 1% or 2% is a significant amount of money for a small market like commodities. At one point, Calsters was considering investing $1.2 billion in commodities, but media reports this week said the proposal has been cut to about $250 million over three years.

McGuire has been an advocate for including gold in pension portfolios. The Texas plan has always had some gold exposure via mining stock holding, he said, but investments in gold as a standalone asset were made in the past few years. That gold allocation stands at 0.30% to 0.40%. The overall target return for the pension fund is to achieve or exceed a time-weighted rate of return of 8%, McGuire said.

Exchange-traded products are how most institutions are buying commodities. For gold, the biggest by far is the six-year-old SPDR Gold Trust (GLD), which is the second-largest ETF anywhere, dwarfed only by the SPDR S&P 500 ETF. The Gold Trust has about $56 billion under management.

Kevin Quigg, global head of ETF Capital Markets with State Street Global Advisors, said the concept of investing in gold isn’t new, but what’s different today is the amount of liquidity and having a physically backed vehicle. Before ETFs, “it was a different marketplace,” he said.

The size of the ETF market has in itself drawn interest to gold, Quigg said. “With the size of the fund at $56 billion, it’s liquid enough in the secondary market that it works as an investment vehicle…. It’s big enough that even funds of some size can come in (without moving the market). Gold is now viewed as an asset class by institutions, which shows they have confidence in the product,” he said.

With a physically backed contract, rather than one using futures, there’s no worry about counterparty risk and particularly no “roll risk,” Quigg said.

The “roll risk” occurs when an investor uses futures and has to exit a nearby or spot month contract and buy a deferred to maintain the position. If the deferred contract is more costly than the nearby, there is a small loss. Traditionally commodities markets have operated in these “carry” markets (also called contango) to make it worthwhile to store the goods for a future date (and thus historically making commodities an inflation hedge). However, when immediate supplies are short the prices will invert, where the front month contract is more expense than the deferred, to draw goods out of storage, sometimes called backwardation.

This roll risk is why some investment managers frown upon commodities as having a place in an institutional portfolio, which typically had a “buy-and-hold” mentality and a long-range target. Yet McGuire said pension funds have both short-term and long-term views. “For asset classes that will always be long-term strategic assets, there are short-term decisions regarding overweighting and underweighting,” he said.

Do Institutions Skew Fundamentals?

Some veterans of the commodities markets view the moves by institutions – not just pension funds themselves – as sometimes creating shortages where none exist and disrupting the hedging tool of the commodities markets, said John Kleist, broker at Allendale. Rising prices make the hedging aspect for producers a losing battle – as an example Barrick and AngloGold had to spend money to exit their gold hedges which in turn lifted gold prices.

Kleist said in the agriculture markets this year there were initial worries about wheat supplies, and the futures prices ran up. That caused importers to buy, fearing another situation like 2008 when there were genuine supply problems. “The spot market collapsed, but the futures market ran up, creating an artificial shortage. The importers overbought, but then they cancelled orders for two years out (when prices fell),” he said.

So if pension funds, which seem to be the last large institutional holdout to enter commodities, throw a few dollars at the market, it could have a further price impact. If they stay, or how long they invest is questionable. “They’ll leave when other markets pose more potential than commodities, but right now that’s way a teacher’s fund is turning to food. But commodities are not an asset class,” Kleist said. McGuire said he personally believes that pension funds will increase their gold assets from the current low base because of concerns over problems with sovereign debt.

McGuire also regards gold as a currency, not a commodity, making it different than other resources.

Andy Smith, senior analyst at Prudential Bache, said some of the claims institutions use for why they choose commodities, specifically gold, don’t always ring true. He also is concerned when investors from large institutions try to justify their decisions even if the markets go against them.

“You trying not to get cynical but it’s easy to do. We’re $1,100 from the lows and the great midriff of the U.S. has moved its girth toward gold. I just wish they wouldn’t speak about it, especially when they say things like, ‘performance doesn’t matter.’ On this planet, performance does matter, it pays the rent. They talk about diversification, and it’s a wonderful thing, but how can you be diversified when it’s only 1%, 2%, 3% of your portfolio? How is that going to save you when the rest of your (portfolio) is going down the toilet?” Smith said.

Smith added that the current investment infatuation with gold for myriad reasons underscores the problems of the world economic outlook. “It’s a sad indictment of our (lives) that gold is more attractive than equities – when it doesn’t do anything.”