Investing in commodities may once have been the preserve of the highly sophisticated investor but Nicholas Brooks believes they now have more mainstream appeal
Commodity investing has historically been the preserve of sophisticated institutional investors. The need for trading infrastructure and expertise to transact effectively in the futures and options markets has kept out many smaller investors. The domination of large institutional investors has also been propagated by the perception that commodities are a highly volatile and speculative asset class not suitable for regular investors.
All that has changed over the past few years with increasing investor awareness of the long-term portfolio benefits of holding commodities and the introduction of exchange traded commodity securities that allow investors to access commodity markets in exactly the same manner they invest in stocks.
Investors have typically held equities, bonds and cash in their portfolios. Finance theory has long suggested that investors are better off in the long run by spreading their investments across a range of asset classes, and that asset allocation may explain 90% of investment returns. With the simultaneous development of finance theory and new financial products, new asset classes have been added to the typical mix of 60% equities and 40% bonds. Investors can invest in real estate, private equity, hedge funds and now commodities. Listings on major European stock exchanges, better distribution, and the growth of pension fund supermarkets, have also enabled investors to gain knowledge of and access to new products in a regulated and safe environment.
Why invest in commodities?
During the stock market boom years of 1982 to 2000, there was no great need to question a significant allocation to equities. However, when the equity market began its poor run of returns at the turn of this millennium, many investors who were still heavily weighted in equities began to ask questions about their asset allocation. There is a large and growing body of research about diversification through commodities and optimal portfolios and this research has shown that a diversified portfolio generally would have benefited from an allocation to commodities. It has also been shown that commodities have often provided timely diversification benefits during periods of financial stress and during equity bear markets (see Chow et al, Financial Analysts Journal, May/June 1999, pp. 65-73) because the correlation between commodities and equities tends to fall or even become negative in such times.
One of the main reasons for investing in a range of different asset classes is to diversify risk. When two assets move in opposite directions, they are said to be negatively correlated, and when their correlation is close to zero, they are said to be uncorrelated. The lower the correlation between two assets, the more a portfolio can benefit from the inclusion of the new asset.
Commodities have historically had a low to negative correlation with equities and bonds. So by adding commodities to an average portfolio, the volatility (risk) of that portfolio has generally been reduced for the same return. Another way of looking at it is that the portfolio return has been increased while maintaining the same level of risk.
The aforementioned theoretical reasons for investing part of a diversified portfolio in commodities are also supported by underlying fundamentals. While demand for commodities has increased, supply has remained stagnant or grown at a slower pace. This tightening in spare availability of commodities has made many commodity prices very sensitive to real or perceived supply disruptions or increases in demand. This is highlighted by recent price spikes in oil on supply concerns, agricultural prices on weather disruptions and some metals prices on power shortages and labour disputes in key supplier nations.
Jim Rogers, self made billionaire and author of Hot Commodities, believes that the commodities boom has another ten years to run. Ten years might seem like a long time, but given the long lag times required to increase production and change demand patterns, and the fact that cycles of under- and out-performance can last 10 to 20 years, it is quite possible that Rogers has underestimated the time remaining in the current commodities bull market.
Unless you are a seasoned stock picker with a good track record, buying the underlying commodity may be the best strategy. Commodity companies often provide less diversification potential as they tend to be more correlated to the equity market they are listed on rather than the underlying commodity they are meant to be exposed to. In addition, commodities are not exposed to management, financial, exploration or operating risks. Due to falling production/reserves, rising costs and changing industry risk profiles (i.e. exploring in new and risky areas), many commodity companies are finding it difficult to outperform the underlying commodity. It should also be noted that many factors which are negative for industry revenues are actually positive for commodity prices.
Exchange traded commodities
With the introduction of Exchange Traded Commodities (ETCs) - listed securities backed by a commodity - most investors can now directly gain exposure to commodity markets. ETCs are bought and sold like ordinary shares and exchange traded funds (ETF). ETCs trade and settle like equities, can be held in ordinary brokerage accounts making asset allocation simple, are listed on the London Stock Exchange and other European exchanges and settle through Crest on the usual T+3 basis. Underlying ETCs are either physical commodities or commodity futures. ETCs currently trading on the LSE include nearly every major individual commodity and broad baskets of commodities such as All Commodities for investors that want the broadest possible exposure in one security or subsets such as agriculture, precious metals, industrial metals and livestock.
Commodities are an asset class that is quickly capturing investor interest. They provide excellent diversification to portfolios constructed primarily of equities and bonds due to their low or negative correlation to the major asset classes. In addition, the long term fundamental investment case for commodities appears strong with growing demand from China, India and the biofuels industry and global supply constraints. The introduction of ETCs now provides regular investors with an easy, cheap and transparent method of adding commodities to their long-term portfolios.
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