While investing in the commodities markets is a fairly sophisticated endeavour, they provide an opportunity for almost any investor to get a piece of the action. Commodities are an alternative for investors who wish to diversify beyond traditional stocks and bonds, or to profit from a conviction about price movements. Years ago, most people did not invest in commodities, because doing so required significant amounts of time, money and expertise. Today, there are a number of different routes to the commodity markets, and some make it fairly easy for even the average investor to participate. Commodities get a lot of attention from the media. The price of oil, gold, corn, soy and hogs are in the market news nearly every day.
Overview of Commodities
From the orange juice we drink to the gas we use to power our vehicles, commodities play important roles in our daily lives. They can be found literally all over the world, and can be traded on the global marketplace as part of a diversified investment portfolio. In fact, billions of dollars are invested in commodities every day.
While they can be traded on either spot (real-time) or futures (options) markets, most individual commodities are traded in the form of futures, where what is being traded is not the commodity itself but rather a contract to buy or sell it for a certain price by a stated date in the future. This carries the potential for wild market fluctuations, but it also offers exciting opportunities for investors willing to ride out market volatility in anticipation of rewards. Like any investment, the goal in commodities trading is to buy low and sell high. The difference with commodities is that they are highly leveraged and trade in contract sizes instead of shares.
A popular way to invest in commodities is through a futures contract, which is an agreement to buy or sell in the future a specific quantity of a commodity at a specific price. Futures are available on commodities such as crude oil, gold and natural gas, as well as agricultural products such as cattle or corn.
Most of the participants in the futures markets are commercial or institutional users of the commodities they trade. These hedgers may use the commodity markets to take a position that will reduce the risk of financial loss due to a change in price. Other participants, mainly individuals, are speculators who hope to profit from changes in the price of the futures contract. Speculators typically close out their positions before the contract is due and never take actual delivery of the commodity (grain, oil, etc.) itself.
Most futures contracts will also have options associated with them. Options on futures contracts still allow you to invest in the futures contract, but limit your loss to the cost of the option. Options are derivatives and usually do not move point-for-point with the futures contract.
Benchmarks for Broad Commodity Investing
One of the most common commodity indexes is the Dow Jones-USB Commodity Index (DJ-USBCI). This is a composite index of commodity sector returns, representing an un-leveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The quantity of each commodity in the index is determined by the average quantity of production in the last five years of available data. When used as an economic indicator, this index will assign a weighting to each commodity in proportion to the amount of that commodity flowing through the economy.
The DJ-USBCI is designed to be a highly liquid index that represents fairly the importance of a diversified group of commodities to the world economy. To avoid overexposure of a particular commodity, the index does not allow any related group of commodities (e.g. energy, precious metals, grains) to make up more than 33% of the index. This forbids a disproportionate weighting of any particular commodity or sector that could negate the concept of a broad-based commodity index and thereby increase volatility. The DJ-USBCI relies on both production and liquidity in determining weightings but has stricter guidelines on the maximum percentages allowed in one particular sector.
The Upside of Commodities
Commodities tend to bear a low to negative correlation to traditional asset classes like stocks and bonds. A correlation coefficient is a number between -1 and 1 that measures the degree to which two variables are linearly related. If there is perfect linear relationship, you’ll have a correlation coefficient of 1. A positive correlation means that when one variable has a high (low) value, so does the other. If there is a perfect negative relationship between the two variables, you’ll have a correlation coefficient of -1. A negative correlation means that when one variable has a low (high) value, the other will have a high (low) value. A correlation coefficient of 0 means that there is no linear relationship between the variables. Typically, equities whether in the form of stocks or mutual funds are closely related to each other and tend to have a positive correlation with one another. Commodities, on the other hand, are a bet on unexpected inflation and they have a low to negative correlation to other asset classes.
Commodities have offered superior returns in the past, but they still are one of the more volatile asset classes available. Make no mistake, they do carry a higher standard deviation (or risk) than most other equity investments. However, by adding commodities to a portfolio of assets that are less volatile, you actually decrease the overall portfolio risk due to the negative correlation and in most cases increase your overall expected return.
How to Invest
Individual commodity futures are an investment for more sophisticated investors. For most investors, the most suitable way to invest in commodities is through a mutual fund. They can be purchased through a ‘natural-resources fund’, which buys companies associated with the mining or production of commodities. Commodities can also be purchased through a ‘raw-commodity fund’, which actually invests in commodity-linked derivative instruments backed by fixed-income investments.
In order to get the true diversification value of commodities and the negative correlation to stock returns, you’ll need to seek out funds with direct commodity investments – since buying a natural-resources fund will typically just add more stock holdings to your portfolio.
During inflationary times, many investors look to asset classes like real-return bonds and commodities (and possibly foreign bonds and real estate) to protect the purchasing power of their capital. By adding these diverse asset classes to their portfolios, investors seek to provide multiple degrees of downside protection and upside potential. What is important is that you draw the line on the maximum correlation of returns you will accept between your asset classes, and choose your asset classes wisely. Given the unique negative correlation that raw commodities have to stocks and bonds, they can be a well-advised addition to almost every long-term investment portfolio.
ABOUT OMEGA CAPITAL
Omega Capital Limited is an Investment management, private equity and investment advisory firm. The company is authorised and regulated by the Securities and Exchange Commission of Ghana.
Kumapremereh Nketiah (JP)
Sophia Obeng- Aboagye
Omega Capital Research
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