Commodity investing has piqued the interest of many a discerning investor. But with the commodity spectrum spanning metals and minerals to sugar and corn, it is important to understand how to invest in them effectively.
Many investors split commodities into two key areas. “Hard” commodities include precious metals and energy-related resources like oil and coal. “Soft” commodities are agricultural products such as sugar or cotton. Both types are influenced by supply and demand factors.
Yet it is not just a demand story. Conservative capital spending and lack of exploration by many of the biggest mining companies in recent years mean that supply is limited in many areas. With shortages of skilled labour and materials limiting the ability of competitors to increase supply, and demand likely to remain robust around the world, prices of hard commodities have been strengthening.
Combined with this is concern about global warming which is creating demand for alternative energy sources. As a result, demand for soft commodities such as sugar and corn for processing into ethanol has grown exponentially. This has created a source of demand which was not present to the same extent in previous cycles and is acting as a positive support for soft commodity prices. With Brazil and Argentina having the most efficient agricultural sectors in the world, it is expected that both these economies and individual companies within them should benefit greatly over the coming years.
There are a number of ways to gain access to commodities, from individual commodity futures and exchange traded funds which are backed by the underlying commodity, through to indices like the Goldman Sachs and DJ-AIG Commodity indices which track price movements through the use of futures.
Investors can gain indirect access to the underlying movement in commodity prices by investing in shares of companies which are closely involved in these sectors, such as miners and oil refiners, or in pooled funds which give exposure to a wider selection of companies operating and linked to commodities.
Each of these investment vehicles requires a different time commitment and level of management on the part of the investor, from periodic monitoring of the unit price and strategy through to active selection and the timing of any investment in the underlying commodities.
There is no single correct answer as to which is most suitable for each investor. It depends on appetite for risk, the amount of time investors have to manage exposure in their portfolio, the degree of confidence they have and the composition of the rest of the portfolio.
Many investors have preferred to gain exposure through specific commodities such as oil or gold or commodity indices. This decision will depend on whether an investor has a view on a commodity group and whether they would like to move actively between groups as investment conditions change.
Indices provide a relatively straightforward way of investing in commodities but can be influenced by flows in and out of the asset class as well as the effects of broader index rebalancing as and when they occur. The benefit of investing in a pooled fund which invests in commodity-related equities rather than directly in a commodity index is that the sector allocation, stock selection and timing decisions can be taken utilising the expertise of the manager within the asset class.
Whether you invest direct or in commodity-related companies through a pooled fund, what is important is that commodities can be a useful complement to an existing investment portfolio.
Much has been written on the benefits of adding commodities to diversify a portfolio’s return volatility as a consequence of their relatively low correlation with other assets over time. Some investors choose to add commodity futures to their portfolios to hedge against inflation.
With the broad range of investment vehicles out there poised to capture the burgeoning demand for energy-related products and agricultural food stuffs, there is plenty of choice to broaden your portfolio effectively.
Ian Pascal is marketing director at Baring Asset Management.