By Jane Merriman

LONDON (Reuters) - Money is still flooding into commodities investments to diversify portfolios despite financial market turmoil, and more pension funds are looking at commodity investments, especially in southern Europe.

"I would expect to see several billion dollars of inflows by the end of the year as new funds consider commodities and implement (investment) programmes in commodities," said Daniel Raab, managing director of AIG Financial Products.

The amount of long-only investments in commodities indexes reached $120 billion by the second quarter of 2007, up 50 percent on the $80 billion invested at the same point in 2006, he told reporters at a Dow Jones Indexes briefing on commodities on Tuesday.

The Dow Jones-AIG Commodity Index has $38 billion of long-only money tracking it, up from $24 billion at the same point last year, he said.

Investment flows into commodities have picked up again after a lull in the summer due to turbulence in financial markets.

This was caused by fallout from problems in the mortage sector in the United States that could still pose a threat to the wider economy.

"We saw a bit of a slowdown in August, but we see it was a temporary readjustment, possibly because equity prices were lower and therefore investors reduced commodity exposure as well," Raab said.

DIVERSIFIER

Commodities are attractive to investors because they tend to behave differently from stocks and bonds.

In 2002, for example, when the Standard & Poors 500 equity index fell 38 percent, the Dow Jones-AIG index was up 34 percent, Raab said.

But so far only a relatively small number of pension funds, for example, are invested in commodities.

"We see growing interest in southern Europe from institutional investors," said Christiaen van Lanschot, managing director of Banque AIG.

Pensions funds typically allocate about 3-5 percent of their portfolio to commodities, but deciding on this investment is a long process that needs approval from trustees.

Commodity index returns were hit last year by the structure of the oil market, but a shift in the oil futures curve this year has been more favourable to index investors.

Investors are also looking for more sophisticated products in commodities.

Raab said investors were concerned about the so-called negative roll-yield in 2006 from investing in commodity indexes.

Last year oil prices nearby were lower than further forward, so this hit returns when the indexes rolled forward their positions in the futures markets every month.

"Now investors are saying how can you enhance returns of the benchmarks," Raab said.

There are also questions over how long commodities will retain their diversification benefits if they become a more mainstream asset class.

"The fundamentals still drive the prices," said Raab. "And we believe commodities are positively correlated to inflation."