The focus of this article will be on key considerations when investing in commodities, because it is essential to have a framework for what to do and what not to do to increase the chances of beating the market. It will also focus on introductory and general concepts of investing in commodities, with more specific discussions in the upcoming issues of this series.
• Diversifying is helpful, but not for all portfolios
One of the main reasons investors choose to allocate their money to a different asset class, such as commodities, is diversification. This may be true from a general perspective because commodities have a lower correlation with stocks and bonds, so during periods where stocks and bonds perform poorly, commodities can help offset losses in an investor’s portfolio. This is further supported by some commodities being a good inflation hedge and may even gain value during inflation. Oil and gold, for example, are considered reliable hedges against inflation and economic uncertainty, as they tend to gain in value when the cost of goods and services rises.
However, it is essential to note that diversification can be more useful if the investor understands the intrinsic characteristics of the commodity they invest in. Depending on the commodity, investors should appreciate its demand and supply characteristics. Macroeconomic and commodity-specific updates and news are also key factors affecting commodity performance. By doing this, it is easier to stay one step ahead of the market and profit meaningfully from investing in commodities.
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Simply putting money into commodities such as gold for the sake of investing is also an acceptable strategy, but only for investors who have diversification as their key investment parameter. Specifically, it is beneficial for investors who purchase a large quantity of an asset class, such as stocks and bonds, and diversify across multiple industries and sectors. It is similar to buying an index, such as the Straits Times Index, S&P 500 Index, or Nasdaq Composite Index. Along with purchasing ETFs of these indices, investors who want to diversify into commodities can also purchase commodity ETFs, such as gold or silver ETFs. This way, although both risk and returns are likely limited, it will fulfil the goal of diversification in an investor’s portfolio.
The exception to this is for investors with just a few stocks or bonds in their portfolio, with each item thoroughly researched and understood. In other words, it is for investors who prefer to hold very few high-quality stocks or bonds rather than a large number of stocks or ETFs in their portfolio. The rationale is that “diversification” in this context means reducing risk by knowing what you are investing in. For example, an expert in the medical field who invests solely in the medical and healthcare sector with a handful of stocks and bonds should not “diversify” into commodities, as they have a lower correlation with stocks and bonds. Instead, they should “diversify” into stocks and bonds in the medical and healthcare sector, which have lower correlation with the industry they have invested in, or even profit handsomely through the use of derivatives and options for stocks which are most volatile within the sector they are an expert in, regardless of general economic conditions. Investors should be cognisant of the concept of opportunity cost because, in the given example, “diversifying” into what you know has the lowest opportunity cost.
• Deciding on the amount of commodity allocation
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If an investor has determined that investing in commodities is practical, they woud need to decide on the appropriate level of exposure or allocation. Futures and commodity ETFs generally provide more direct exposure to the underlying commodity, as they are fully exposed to its price volatility.
Since futures contracts expire, investors need to be wary and “roll” their contracts to maintain exposure to their invested commodity. They can also buy commodity ETFs, which may or may not require rolling, depending on the commodity. Alternatively, investors can purchase shares in a company whose primary business is commodities. All three methods have different implications for an investor’s portfolio.
When deciding on the commodity allocation, investors should compare and contrast the fees for each of the three methods. More frequent trading in an approach may lead to higher costs and some methods may require more monitoring than others. If investors choose to invest in companies whose primary business involves commodities, it is imperative to understand how sensitive the industry is to the volatility in commodity prices. For example, a company that only does oil exploration may be directly affected by crude oil prices, while a company with both upstream and downstream businesses across various commodities may be only partially exposed to crude oil prices.
• Understanding risks associated with commodities
A key risk associated with commodities is that they are a non-income-generating asset class. This means it does not pay dividends or interest like stocks and bonds. An investor’s return in commodities is mainly determined by the price of the underlying commodity and is relatively volatile compared to other asset classes. Not being able to generate income denotes more risk, as investors do not earn any actual or realised returns until they liquidate their position in the invested commodity.
Also, margins and leverage are commonly used by futures commodities traders and investors, and returns can be highly volatile depending on the leverage utilised. Though higher leverage can yield higher potential returns, the risk is also magnified, so commodity investors should manage their risk carefully. Sharp movements in commodity prices can easily wipe out an investor’s entire portfolio if leverage is not managed properly, so it is advisable not to leverage on speculations.
Investors with commodity exposure through stocks must be wary of company-specific or idiosyncratic risks, in addition to the general risks of investing in commodities. Investors can manage this by conducting thorough fundamental analysis of the companies they invest in.
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Conclusion
The overarching principle of investing in anything is to understand the financial instrument or asset class in question. To increase the likelihood of beating the market consistently, investors should focus on commodities they know well. The first step is to select the commodities carefully.
Next, determine the method for gaining exposure to commodities. This can be through futures contracts, commodity ETFs or buying shares in commodity stocks. It is important to compare fees for each method and be wary of the inherent risks, especially when using leverage.
Investors should also determine the purpose of diversifying into different commodities. Is it for diversification purposes? Is it for hedging purposes? Is it a major source of investment return? The higher the exposure to commodities, the more the investor should monitor their investments, as commodities are known to be volatile.
This article provides a general introduction to commodities. A deeper discussion of individual commodities such as gold and crude oil will appear in upcoming issues of this series.
Disclaimer: This article is strictly for information purposes only and does not constitute a recommendation, solicitation or expression of views to influence readers to buy or sell investment instruments. Any personal investments should be made at the investor’s own discretion, or after consulting licensed investment professionals, at the investor’s own risk. The author of this article does not hold or own any investment instrument featured in this article or have a vested interest in it at the time of writing.
