Commodities will battle to attract fresh money inflows this year as doubts remain about demand from top consumer China and after sharp losses last year and higher correlation with other asset classes, which diminished arguments for diversification.

Investment flows into commodities slid by 78 percent in 2011 to $15 billion (9.45 billion pounds), the weakest figure in a nearly a decade, including net withdrawals of $7.7 billion in December, according to Barclays Capital .

January saw a slight recovery as investment in commodities turned positive, Barcap said on Monday. The investment bank was upbeat about the prospects for commodities this year.

But some fund managers have been wary about how quickly investors will return to the sector.

I think (for) the ones who were burnt last year, it might take them a while to get back into commodities, said Frances Hudson, global thematic strategist at Standard Life Investments in Edinburgh, which has $248 billion of assets under management.

The biggest driver last year, certainly for the passive money, was the fact that commodities didn't perform very well, Hudson said last week.

The 18-commodity Thomson Reuters Jefferies CRB index <.CRB> shed 8.3 percent last year, but losses for many hedge funds were much deeper due to the sharp swings in prices.

Among hedge fund strategies, the basic materials/energy hedge fund sub-index was one of the worst performing sectors last year, losing 16.9 percent, compared with combined gains of nearly 60 percent for the previous two years, according to Hedge Fund Research Inc.

Absolute return is the second most important reason to invest in commodities after portfolio diversification, according to investors surveyed by Barcap.

Although commodity prices have had a bright start this year, gaining 6 percent based on the CRB, another fund manager said investors were wary after the rollercoast ride last year, with sharp gains and equally sudden drops.

I think the money will come in slowly this time. It's there and will be invested, but you will see a slower inflow of money, said Gregory Cain at Ebullio Capital Management, a firm near London that specialises in commodities.

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Graphic on commodities correlation with equities: http://link.reuters.com/jaz44s

Graphic on asset performance in 2011: http://link.reuters.com/vum35s

Graphic on asset performance in 2012: http://link.reuters.com/muc46s

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STRONG CORRELATIONS

Commodities had attracted a burst of investment flows starting in 2001 as institutional investors sought to capture strong growth in emerging countries and banks sold commodity index products as tools for diversifying portfolios.

But since the 2008 financial crisis, commodities have shown much stronger correlation with other risky assets such as equities, providing scant diversification for institutional investors.

During the 10 years before 2008, the average correlation between the S&P GSCI commodity index <.SPGSCI> and the MSCI world equities index was zero, but during the past three years it has soared to 70 percent.

Heady price gains in commodities outweighed the lack of diversification in 2009-2010, but the issue may be coming to the fore following their weak and volatile performance last year.

We were in an environment where everything was trading together. The degree of correlation between asset classes was such that ... you weren't being paid to diversify using commodities, said Hudson.

Almost half of the investors in the Barcap survey said diversification was the main impetus for them to put money into commodities, and a quarter of them said they cut exposure because of the now high correlations with other assets.

Asset managers said last year's fluctuations in performance and high correlations were probably more of a concern for investors who entered the sector last year than for long-term investors such as pension funds already holding commodities.

Kevin Norrish, managing director of commodities research at Barcap, said high recent correlations are due to the financial crisis, but others say they may also be due to the huge influx of funds into commodities.

Total cumulative assets under management were $399 billion at the end of last year, up from only $10 billion in 2001.

I don't think investors believe that the unusual conditions of the last few years have undermined that very long track record of negative correlations, Norrish said.

My own view is that this year you will probably see less correlation, because so far at least the big macro scare story is dissipating.

CHINA KEY

Many investors so far this year have opted for equities and bonds over commodities after Western central banks extended the period of low rates, while the outlook for Chinese growth remained unclear, said Koen Straetmans, senior strategist with ING Asset Management in the Hague, which has about 330 billion euros under management worldwide.

They don't want outright bets on a cyclical improvement in China, which is the lead demand factor for commodities, but they prefer to play it straight on yield-bearing risky assets, said Straetmans, who provides commodity weightings advice for a range of ING multi-asset funds.

World stocks, as measured by the MSCI world equity index have gained 10 percent so far this year, while the CRB index is up 6 percent.

The exception has been crude oil, which has seen fresh money long positions on the back of tension between Iran and the West. Brent crude has gained 15 percent in dollar terms.

A rebound in Chinese growth later in the year, however, could spark more inflows into commodities.

I think going further in the year, everything will depend on the evolution in China ... logically you would expect there to be a cyclical rebound, probably also based on policy easing, and that obviously could be the trigger for renewed inflows into the asset class, Straetmans said.

(editing by Jane Baird)