Commodities remain unfamiliar territory for most pension funds but many are considering investing in the sector as part of a broader drive to diversify risks and enhance returns.

In January, Hermes announced a £1 billion (€1.4 billion) investment into commodities on behalf of BT Pension Scheme, its owner and biggest client. It was the largest single allocation to commodities by any UK institutional investor and created one of the largest commodity funds.

Charlie Metcalfe, deputy chief executive of Hermes, says: "We feel enthusiastic about the level of interest we have seen from other large funds about investing in commodities and we are sure that we will hear about more funds making significant allocations in due course."

Helped by strong growth in China, energy and metals prices have soared over the past three years, creating a "supercycle", according to Citigroup, where demand for commodities is expected to stay stronger for longer. Recent performance is underpinning current demand.

The Goldman Sachs Commodity Index (GSCI) returned 28.1 per cent last year, outperforming global equities and bonds that delivered 12.4 per cent and -6.3 per cent respectively.

Last year's performance was stellar but commodities have a proven track record stretching back more than 43 years. "Even a small allocation to a commodity index in an overall portfolio helps to enhance returns and reduce volatility," says Michael Lewis, global head of commodities at Deutsche Bank.

Commodities also offer powerful diversification benefits. The negative correlation holds up in periods when equity returns are low - a time when diversification earns its keep.

A key attraction is that commodities provide a better hedge against inflation than equities or bonds. Commodity futures are positively correlated with inflation while equities and bonds are usually negatively correlated with inflation. This might seem less important in the current low inflation environment, but commodities have this benefit when there are unexpected increases.

In Europe, some pension providers from the Netherlands were investing in commodities from 2001 onwards.

PGGM, the Dutch pension fund for the healthcare sector, has committed €3.6 billion to commodities or 5 per cent of its total €71.5 billion portfolio. PGGM's 2005 report shows commodities were the second best performing asset class - behind private equity - last year, returning 26.9 per cent. Over the past five years, returns have averaged 11.5 per cent, making commodities, along with property, PGGM's joint best performing asset class.

ABP, the Dutch civil service pension scheme, has 2.5 per cent of its total portfolio in commodities. "Comparable to other asset classes, commodities tend to have a relative high [ positive] correlation with inflation, which is beneficial for a pension fund with indexed liabilities," says Frank Asselbergs, ABP fund manager.

Commodity investing is now being more widely adopted by UK pension fund managers. Watson Wyatt, the pension consultancy, says five UK institutions invested £500 million last year and a larger number of institutions are likely to follow suit this year.

"Commodities are a relatively easy asset class to understand and to invest in so they provide low hanging fruit for pensions funds' diversification purposes," says Alasdair Macdonald, senior investment consultant at Watson Wyatt. The Republic of Ireland's National Pensions Reserve Fund decided in February 2005 to invest 18 per cent of its portfolio into alternative asset classes comprising property, private equity and commodities. It has invested €170 million in commodities and plans to invest a further €30 million in forestry, representing 1.3 per cent of its portfolio.

Many pension fund managers have adopted passive investment, following the GSCI. It is heavily weighted towards energy so a potential worry is that a return to average oil prices could hurt.

Hermes decided to track the GSCI Light index that has a smaller weighting for oil and gas, reflecting concern about the run-up in energy prices.

Robert Howell of Schroders cautions that fund managers should consider a greater focus on active management strategies as more volatility in commodity prices appears likely. His actively managed fund has outperformed the GSCI by 14.2 per cent since inception in late October 2005.

Macdonald says: "We find clients are opting for passive investment strategies with commodities because there are not sufficient alternatives. If there were more actively managed products available, we think pension funds would be interested."