SMSF Investing Education & Strategies

Commodities

Commodities are raw materials with tangible properties that are used to create the products that we buy and consume. Commodities can include agricultural products such as wheat and soybeans, energy products such as oil and gas, and metals such as gold, silver and copper. There are also “soft” commodities, which are those that cannot be stored for long periods of time, which include cotton, coffee, cocoa and sugar.

From an investment perspective, commodities can be looked at as a distinct asset class with returns that are largely independent of stock, property, and bond returns. Adding broad commodity exposure is a way of helping to diversify a portfolio of stocks, property, and fixed interest, lowering risk and potentially boosting return. The ability to achieve this diversification has been made easier with the development of investment products that passively track a broad range of commodities.

Why invest in commodities ?

Over the past decade, there has been a huge revival of investor interest in commodities . This has been largely due to a surge in commodity prices, which has been driven by increased demand from China, India and other emerging countries that need oil, steel and other commodities to support manufacturing and their vast infrastructure development. On the supply side, there had also been a lack of investment, with infrastructure bottlenecks and other economic factors supporting these price gains in commodities. Now whilst attractive returns have been an obvious reason for increased investor interest in commodities, it has not been the only factor. Commodities can also provide other benefits, which include enhanced portfolio diversification and a hedge against inflation.

What's interesting about commodities is that they are “real assets”, unlike stocks and bonds, which are “financial assets”. Therefore, commodities can often react to changing economic conditions and fundamentals in ways that are different from traditional financial assets. For example, in an environment of rising inflation, commodities are one of the few asset classes that can actually benefit from this. It goes that as demand for goods and services in an economy increases, the price of those goods and services usually rises as well, and hence the prices of the commodities used to produce those goods and services increase. Therefore, if commodity prices rise when inflation increases, investing in commodities may provide portfolios with a hedge against inflation. In contrast to this, stocks and bonds will generally perform better when the rate of inflation is stable or slowing. Higher inflation lowers the value of future cash flows paid by stocks and bonds because those future dollars can't buy as many goods and services than they would today. Think about the 1980s and 1990s - inflation fell and stocks and bonds experienced bull markets. For these reasons, returns from commodity indices have tended to be largely independent of stock and bond returns, but positively correlated with inflation.

This lack of correlation with stocks and fixed interest may well be the most significant benefit of broad exposure to commodities: diversification. Assets do not move in sync with each other in a well diversified portfolio, which generally reduces the volatility of the overall portfolio. Lower volatility reduces portfolio risk and should improve the consistency of returns over time. But of course, diversification does not ensure against capital loss.

How to invest in commodities ?

Investing in or getting exposure to commodities has been a challenge in the past. Attempting to invest in physical commodities— say a barrel of oil, or a bushel of wheat—is very impractical and unrealistic. Hence investors have historically looked for commodity exposure either by purchasing commodity-related equities (shares such as BHP) or even through an actively traded futures account with a futures broker.

However, from a top down portfolio perspective, these investment strategies may not capture the potential diversification and other benefits that can come from commodity exposure in a portfolio. Commodity-related equities will not necessarily reflect changes in the price of commodities. For example if a gold producer has already sold its supply on a forward basis, the producer’s stock price may not fully benefit from a rise in the price of gold. Commodity-related equity returns can also be affected by the company's fundamental strength (or lack thereof), management abilities,and of course they will likely have a higher correlation to the movement in the equities market than the commodity market. Similarly, actively traded commodity futures accounts also may not provide the benefits of commodity exposure as these accounts tend to reflect the investor or broker's skills at selecting the right commodities, at the right time, rather than the inherent returns of the commodity market.

Commodity investment can be in the form of either exposure to an entire index, or alternatively individual commodities (such as oil, gold etc). The key advantage of commodity exposure that tracks a broad index is that commodities are not highly correlated with each other, such that those index returns should be less volatile than the returns on an individual commodity. Further to this, commodity indexes themselves have existed for decades, which provides plenty of historic data for asset allocation studies and research.

So how do you get exposure ?

The emergence of investment vehicles such as Exchange Traded Funds (sometimes also called Exchange Traded Commodities in this case) and commodity CFD's that can track individual commodity futures or entire indices has provided investors with probably the most useful option for gaining exposure to commodities that may offer better potential to capture the full benefits of the asset class . ETF's and CFD's can either track commodity index returns providing passive exposure to a broad range of commodities, including energy, livestock, grains, industrial metals, precious metals and “soft” commodities, or alternatively you can invest in just one or a few. Generally an index is a better option for a longer term investor wanting the broad benefits of the asset class.

At present in Australia we only have precious metals listed as ETF's / ETC's on the ASX. However, on international exchanges there are many commodity ETF's to choose from, so if your broker can trade international shares, then you can generally get access to these ETF's. CFD providers will have a list of commodities that it offers CFD's on, which may be a bit different from one broker to the next. And of course, futures contracts can also be used for various types of commodities exposure, however ensure you use an experienced futures broker who can help you with this as this is no place for the inexperienced - mistakes can be incredibly costly.