Based on United Nations’ estimate, it took the world until AD1800 to put a billion people on the globe and another 120 years to add on the next billion. Guess how long did it take to go from its 5th billion to 6th billion in population? Less than 15 years! The rate of increase is still gaining steam. You can be sure that the demand for resources will only increase as the world population continues to expand at this alarming rate. In this case, investing in commodities makes sense before the world demand drives up the prices in the future.

What drives commodity prices?

Based on simple economics, the price of a particular commodity is determined by the demand and supply situation in the market for that commodity. While the statement is simple, it is probably the single and most important factor to consider when investing in commodities.

Importance of having commodity exposure in your portfolio

Assuming you buy the story that the world is resource hungry, having commodity exposure in your portfolio makes a lot of sense. In investments, the basic logic of making profits is very much the “buy low, sell high” mantra.

Secondly, investing in commodities provides a good form of diversification for an existing portfolio of equity and fixed income investments. This is because the correlation* of commodities with traditional assets classes such as fixed income, are usually low or even negative.

Table 1: The correlation matrix for CRB Commodity index with respect to S&P 500 and Total Return Index of US treasuries

If the correlation is 0, the movements of the asset classes are completely random and unrelated whereas a negative correlation indicates that if one asset class moves, the other asset class will move by an equal amount in the opposite direction.  Simply put, an asset class with low or negative correlation with your existing portfolio assets provides a good diversification effect for your portfolio.

Lastly, commodities are usually treated as a hedging tool against inflation, wherein the prices of commodities generally track the inflation trend. If an investor wants a portion of his portfolio to be largely inflation-proof, commodities are a good addition.

Exposure to commodity asset class

There are a couple of methods to get an exposure to commodities in your portfolio. Here’s a quick overview:

Investing in commodity futures or commodity ETFs allows you to have direct exposure to any change in commodities prices, while investment in commodity-related companies or commodity-themed mutual funds can give you an indirect exposure as these investments move in close tandem to the commodity prices as well.

We shall also cover the pros and cons of the various investment instruments.

a) Commodities Futures
Pros: This is the most direct form of commodity exposure. Also, you get to select the specific commodity you want. For example, if you are bullish in copper, you just participate in copper futures.

Cons: The minimum trade size is usually too large and expensive for retail participation. Moreover, you need an in-depth knowledge to pick up the right commodity for investment. Furthermore, futures are essentially derivative instruments. It is not an exaggeration to say that even some finance professionals are unclear of its exact workings.

b) Commodity ETFs
Pros: A cost effective way to get an exposure to a basket of commodities. Since you literally buy into the index, you save substantially on the annual management charges.

Cons: The weighage for commodities in the index is relatively fixed and you have no control how the index weightings are changed. Unless the entire commodity market rallies, you might not be able to realize profit that might come by picking a specific commodity.

c) Commodity-related Companies
Pros: The listed companies are easier to comprehend than futures or ETFs segment for the retail investors. Moreover, the lot sizes of stocks are usually not exorbitant, with exception of blue chip counters.  Furthermore, by buying a company’s stock, you are essentially buying the company’s ability to generate profits. Companies with good management can usually still churn out profit to negate any adverse movements in commodities prices.

Cons: On the other hand, companies with bad management can produce losses even when commodities are rallying.  Hence, investors with preference towards commodity-related companies need to have a complete know-how of the management, business plans, revenue model, and economic cycle of the companies in order to choose the right stocks.

d) Commodity-themed Mutual Funds
Pros: By buying into such mutual funds, you are engaging investment professionals to do the selection for you. You are literally hiring the best in this field to help you earn profits. More importantly, the fund manager has the flexibility to overweight those commodities/stocks he feels have greater potential and underweight those commodities/stocks which he feels may underperform.

Cons: You pay annual management charges to the fund manager to manage your fund. And this amount could be larger than the fees you pay for ETFs. 

Commodities funds available on FSM

Commodities investing can become a valuable part of your portfolio. At Fundsupermart.com, we offer the following funds to investors who would like to have an exposure to commodities via mutual funds:

• Birla Sun Life Commodity Equities Fund
• Mirae Asset Global Commodity Stocks Fund

*Correlation is defined as the statistical relationship between 2 variables. Correlation ranges between -1 and +1.