Investing in Commodities – Why, How and Does this Suit Me?

Posted on: 3rd May 2016 in Investments

There are numerous reasons why you should choose to invest in commodities. But what are commodities and how do they compare with other asset classes and securities? Commodities are tangible goods that are the basic buildings blocks of the global economy. They can be exchanged with one another and can range from goods consumed directly in everyday life – for example, agricultural commodities like grains, food and fibre or livestock and meat – to inputs that are used to create other products such as oil and gas commodities, natural resources like timber and rubber – and precious metals like gold and silver. However, commodities are not your typical investment – they do not pay any interest or dividends but tend to perform well in the wake of inflation. Holding a bar of gold does not generate any cash and will never turn into two bars of gold. Over time it will just be in your possession, costing you money in storage, insurance and perhaps also as management fees. So…

… Why Invest in Commodities?

Commodities are a means by which an investor can diversify their portfolio beyond traditional investment holdings such as shares and bonds, or profit from informed judgements on price movements in a specific sector or geography. The commodity sector has little correlation with the stock market and foreign exchange (FX) market, which means if equity or FX markets were to fall, the price of commodities will not necessarily decline – and vice versa. Also, inflation – the bane of stocks and bonds that erodes their value – tends to work well with commodities. By definition, inflation drives up prices of commodities. So commodities can play a useful long-term role for private investors as a portfolio diversifier, a means by which to protect from inflation and a means by which to generate wealth from specific industries or regions. However, it should be noted that while commodities have shown strong performance in periods of high inflation, commodities can be much more volatile than other types of investments.

How to Invest in Commodities

There are several ways to consider investing in commodities.

1. Physical Commodity Investments

Purchasing physical raw commodities, such as gold, means actually buying and holding the asset. This comes with the burden of storage. But there are ways of managing this. For example, several bullion firms offer online gold dealing services along with safe storage and insurance solutions. However, secure storage is costly. Investors will also need to ensure they buy the asset at a good price. This can be difficult to achieve, particularly when buying smaller quantities.  Moreover, there are other factors to consider based on the type of commodity such as perish-ability – as is the case with some types of agriculture commodities – and maintenance. Overall, physical commodity investments are best suited for industrious investors.

2. Investing through ETFs, ETCs, or the Futures Market

You can also invest through the use of futures contracts or exchange traded funds/commodities (ETFs/ETCs) that directly track a specific commodity index or commodity. Futures are the riskiest and most straight forward investment. These are highly volatile and complex investments that are generally recommended for experienced investors only. On the other hand, equity-based commodity ETFs invest in shares of commodity companies – say Exxon (oil and gas) – whereas ETCs are instruments that track the price of the commodity, or a basket of commodities. They can either be physically backed by holdings of the commodity itself or may use swaps with other financial institutions to provide the exposure. Most ETFs only track an index such as oil futures, so there is little room for manoeuvring. Some ETCs also allow investors to ‘short sell’ or ‘leverage’ their investment, allowing investors to take bets on the price either falling or rising. However, as with futures, investors should be very careful here, as although there are potential gains to be made, there could be huge losses too. Furthermore, there are various levels of tracking errors involved with these securities resulting in the actual return realised by an investor being different than the actual returns of the underlying commodities.

3. Investing through Managed Funds

A managed investment fund is another way for you to gain exposure to commodities since it invests in commodity-related businesses. A managed fund also provides a degree of diversification, since it will typically invest directly in a variety of commodities as well as in production companies. For instance, an oil and gas fund would own stocks issued by companies involved in energy exploration, refining, storage and distribution.

4. Investing in ‘Commodity Stocks’

Another alternative is to directly buy shares of commodity companies. For example, you could buy shares in companies such as Exxon, BP and Royal Dutch Shell in order to access the natural resources markets. These can provide a form of leverage on commodity prices. For instance, a mining company involved in gold extraction obtains higher profits as the price of gold rises, since general costs of operations do not necessarily fluctuate proportionately. However, since ‘commodity stocks’ are equities. they are influenced by the broader ebb and flow of the market and therefore offer a lower amount of risk diversification benefits than the other options. Moreover, commodity stocks and commodities do not always deliver the same return. As you can see in the chart below, there are times when one investment outperforms the other. Maintaining an allocation to each group may help contribute to a portfolio’s overall long-term performance.

So, Are Commodity Investments for Me?

Commodity investments do offer diversification benefits because their return characteristics are different than those of stocks and bonds. A study published in the Journal of Investing concluded that, “portfolio risk was reduced significantly when 10% or more of the portfolio was allocated to commodity futures,” but further noted that “a 5% allocation to commodity futures was not sufficient to produce a significant reduction in risk.” So having some exposure to commodities can be part of a well-diversified portfolio. But due to the costs and complexity mentioned above, commodities are an investment area which an investor would be best suited to consider after achieving certain leverage in their portfolio. Does someone with a £10,000 portfolio need to include commodities in order to diversify? Probably not. But an investor with a £100,000 portfolio should unquestionably begin adding commodity exposure on a smart, cost-effective basis to their portfolio in order to diversify away the risk and maximise return. Keep in mind that investing in the commodity market is not as easy as purchasing an FTSE-100 ETF. Deciding on the right investment vehicle is crucial so as to not erode your potential return prospects. Also, futures and ETC contracts are not created for amateur investors – they are technically complex and bear high risk. A crucial tip from us would be to ‘not invest in anything you do not understand’. Here at Holborn Assets, we carry the requisite experience and expertise to help you identify whether commodity investments make sense for you and if so, to help you get started with your investment drive. Get in touch with a qualified independent financial adviser today!