Commodities have had a tough year with fluctuating oil and gold prices. This volatility poses the question of whether commodities deserve a place in a portfolio? The sector has not been the most favoured among investors, possibly due to the lack of knowledge and expertise around it. Most investors tend to focus on familiar asset classes, like equities and fixed income and shy away from alternatives such as commodities.
But market analysts believe the outlook for investing in commodities during a rising interest rate environment could be more positive. This is because commodities generally outperform other asset classes during hawkish monetary policy, especially compared with equities.
But investors’ low comfort level remains an issue. Most investors have a greater understanding of how stocks and bonds function. As a result, they can find themselves unable to understand the moves in a commodity market, especially those prompted by unforeseen factors such as weather or geopolitical risk, which can impact on commodity price trends.
Back to basics
Commodities are generally regarded as a single asset class but there are various sub-categories, the three main ones being agriculture, energy and metals. Agriculture includes basic resources such as sugar, tea, coffee, soybeans and corn; energy includes iron ore, crude oil and coal; while metals include gold, silver, palladium and platinum.
Within these categories are a number of variations of products that offer either a single commodity or a combination of exposures to commodities. Investors looking at the commodities market can invest in various ways – for example through a futures contract, commodity stocks, exchange-traded funds (ETFs), exchange-traded commodities (ETCs), mutual funds and index funds.
Products offering exposure to commodities can include a physical commodity – such as the SPDR Gold Trust, which is the biggest physically-backed ETF – futures tracking a single commodity, or a basket of commodities, and equities which have exposure to commodities.
Commodity ETFs and ETCs trade like stocks and allow investors to participate in commodity price fluctuations without investing directly in futures contracts. One of the reasons for the growing popularity of these products is that they provide investors with exposure to various commodities without having to learn how to purchase futures or other derivatives.
There are also lower management fees although one element to consider is risk diversification. ETCs can provide an easy way to participate in the price fluctuations of a commodity or a basket of commodities.
Top performers
By way of an example of funds investing in commodities, Table 1 looks at the top performing commodity ETFs available in the UK, ranked over three years.
The top performing fund as of 1 August 2015 is ETFS Daily Short WTI Crude Oil with a return of £1,471 based on a £1,000 initial investment. Its performance over one year returned £1,999.
Crude oil has had a rollercoaster ride this year. After fairly smooth trading in May and June, it lost close to 21 per cent in July, the worst month since October 2008. This was attributed to a number of factors, such as weak data from the US and the Chinese market slump. Commodity analysts have predicted oil prices revisiting their previous low of the year in the second half, pushing down oil ETFs.
The second best performer has a high concentration in coffee. The ETFS Daily Short Coffee returned £1,218 on an initial investment of £1,000 over three years. Other funds represented in the Table focus on palladium, energy, soybeans, cocoa and precious metals. All but three of the funds returned lower than their initial investment over three years. Funds associated with a basket of commodities such as the ETFS GBP Daily Hedged All Commodities fund also underperformed.
Risks to consider
ETFs have become an increasingly popular way of investing in recent years as they offer a number of advantages over traditional actively-managed funds. Some of the reasons investors tend to prefer ETFs over actively-managed funds include lower costs, potential tax efficiencies, intra-day trading and enhanced transparency. But ETFs have their drawbacks as well.
For instance, a big move in a specific commodity may not be reflected point-for-point by the underlying ETF. And not all commodities have an ETF associated with them. Advisers also warn of credit risk associated with the issuer of the ETF.
Investors should do their due diligence to find out more about elements such as underlying assets, strategies and the liquidity of the ETF before taking the plunge.
And, when it comes to commodities, investors first need to understand and put a strategy in place before investing. It is important to benchmark returns and measure risk tolerance before deciding to add commodities to a portfolio.
In addition, analysing factors such as tax implications and prospective drivers of price action should be on the list when considering allocation to the space.
Five questions to ask:
1. Why should I invest in commodities?
Commodities have offered superior returns in the past and by adding them to a portfolio of assets that are less volatile, you can actually decrease the overall portfolio risk.
2. What does it buy?
Investing in commodities could mean investing directly in physical commodities such as gold or oil. In other instances, investors buy derivatives.
3. What can I buy?
Whether it is physical commodity or a derivative, ETCs can range from either investing in a single commodity or a basket of commodities. The four major areas include energy, agriculture, precious metals and industrial metals.
4. Are they available to invest in the UK?
Not all commodities are available to buy directly in the UK but now hundreds are available to buy in the form of an ETF or ETC.
5. What are the risks to consider?
Investors tend to stay clear of the commodities sector due to volatility. Single assets such as oil and gold have had fluctuating performances this year and investors looking to take the plunge in these sectors should measure their risk tolerance before investing.
