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Commodity play for your portfolio
January 7, 2010

In this article, we shall explore the basics that an interested commodity investor needs to know.


Author : iFAST Research Team



Untitled Document

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.

It is akin to saying that to profit from investing in commodities; one must have the foresight to envisage either one of the following 3 scenarios:

  • A boom in demand for that commodity, with no arguable increase in supply
  • A crunch in supply for that commodity, with consistent demand
  • A boom in demand for that commodity, accompanied by the crunch in supply

An investor who has invested when scenario (c) occurs is in for supernormal profits.

Example: Oil Crisis

The scenario (c) is best manifested in Chart1. The chart shows the run-up in crude oil prices in recent decade.

The oil prices have seen an astronomical rise till the global economic crisis after which the oil prices bottomed out before rising again. The characteristics fit scenario (c) almost seamlessly.

 

Source: Bloomberg

 

While OPEC shows an increase in proven oil reserves, it fails to address the question of extractability. Not all oil reserves are the same, there are those that are more difficult to extract. In the case of oil, the crunch in  supply refers to the massive reduction of easily extractable oil.

Energy starved nations like China and India have increasing demand due to higher consumption and rapid industrialisation. It will not be surprising that this overwhelming demand will drive up global prices significantly.

Assuming you had 10 barrels of oil stored at the back of your home, purchased at the start of the decade, you will probably be making 2 to 3 times your initial cost of purchase. Hence, as an investor, to profit from commodities, you need to be holding or owning (directly or indirectly) some of these commodities before any of above scenarios take place.

Source: OPEC’s Estimate

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

 

CRB Commodity Index

S&P 500

Total Return Index of US treasuries

CRB Commodity Index 1 -0.564 -0.318
S&P 500 -0.564 1 -0.129
Total Return Index of US treasuries -0.318 -0.129 1

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:

Direct Exposure

Indirect Exposure

Commodity Futures

Stocks of Companies dealing directly with Commodities

Commodity ETFs

Commodity-themed mutual funds

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.


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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