Powerful institutional investors continue to buy into commodities despite sharp price falls in some markets as their key role as a portfolio diversifier really comes into play, fund managers and analysts said this week.

Investing in raw materials such as crude oil, copper or lean hogs is no longer the easy one-way bet of two years ago.

Commodity indexes -- still the most popular initial entry portal into the asset class -- have underperformed against the major equity indexes so far this year, while an unusual price structure, especially in the energy sector has eroded or even eliminated previously profitable fund returns.

But it is just this relationship with other asset classes that makes commodities so attractive in investment portfolios.

Most large investors, like pension funds or big wealth managers, allocate between 2.5 to 5 percent of their portfolio to commodities, which often generate positive returns when stocks and bonds decline and protect against inflation.

The correlation between commodities and equities has turned more negative than a year ago so as a result the diversification argument has actually increased, said Francisco Blanch, head of global commodity research at Merrill Lynch.

Year-to-date performance of the major commodity indexes has been overshadowed by buoyant equity markets this year and is a far cry from the double-digit gains of 2005 and early 2006.

In the year to end-May the strongest performer was the Dow-Jones-AIG Commodity Index, with gains of 5.9 percent. That compares with a 9.3 percent rise in the Dow Jones Industrial average and an impressive 19 percent gain for Germany's benchmark DAX index of major companies.

The institutional interest we see in commodities is driven much more by the desire for diversification than it is by the view that tactically commodity prices will go up in the short term, said Bob Greer, real return product manager at America's giant bond investor PIMCO, which manages over $14 billion in commodity-linked strategies.

He said there was very definite growth in investor demand for products and strategies that tracked the indexes.

IN SEARCH OF ALPHA

We see more and more mid-sized or large institutional investors in Europe go into commodities...since mid-2006 they are looking for new 'intelligent' indexes, said Guillaume Picot, global head of underlying structuring for equities and derivatives at BNP Paribas.

Blanch said investors were looking to boost returns through more sophisticated tools, known as commodity alpha.

This includes long/short strategies, investing in longer-dated commodities rather than in the front two months were there is greatest liquidity but increasingly less return and taking advantage of seasonal variations in some markets.

Commodities trading volumes have continued to pick up, which contrasts with the fund flows into passive investments, suggesting that the money is still swilling around in there, it's just a question of where it's being applied, said Frances Hudson, investment director at Standard Life.

Barclays Capital said in a recent note that there had been a clear change in investor flows in the U.S. commodity index-linked mutual fund sector, estimating a net outflow of $436 million in the past 12 months. That compares with inflows of around $5 billion in May/April 2005/06 and 2004/05.

We doubt this trend marks a change in overall investor flows into the sector, but is a reflection of the increasing number of alternative investor options, it said.

HSBC Bank launched a new range of investment products on Wednesday that gives long/short exposure.

We are seeing a lot of investor interest in commodities, and we see this as a continuing trend, said Adam White, HSBC'S head of Structured Fund Solutions EMEA.

Money is also flowing in thick and fast to actively-managed commodity hedge funds. Standard Life's Hudson estimated that their number had tripled in the last year and Blanch spoke of a wave of money into certain hedge funds.

There is an estimated $120-150 billion invested in commodities indexes, while hedge funds manage about $1.5 trillion. So commodities as an asset class has a huge future, BNP Paribas' Picot said.

Germany Crude oil Investment BNP Paribas