Commodity Investing or Equity Investing?

WEALTH CREATION

The commodity market has evolved significantly from the days when farmers hauled bushels of wheat and corn to the local market. Commodities are raw materials used to create the products consumers buy.

Commodities include agricultural products such as wheat and cattle, energy products such as oil and natural gas, and metals such as gold, silver and aluminium. There are also “soft” commodities that cannot be stored for long periods, which include sugar, cocoa and coffee.

In the 1800s, demand for standardised contracts for trading agricultural products led to the development of commodity futures exchanges.

Today, futures, forward and option contracts on a variety of agricultural and energy products, metals and soft commodities can be traded on exchanges around the world.

Commodities have also evolved as an investment asset class with the development of commodity futures indices and, more recently, the introduction of exchange traded funds (ETFs) that track commodity indices.

Is investing in commodities a wise choice?
Investors’ interest in commodities has soared in recent years as the asset class has outperformed traditional assets such as stocks and bonds.

The performance of commodities is usually measured by the returns on a commodity index, such as the Dow Jones UBS Commodity Index, which tracks the returns of a passive investment in 19 different commodity futures contracts (see table).

In our opinion, commodities are poised to continue to perform strongly in the long run for the following fundamental reasons:
• The rising income levels and the emergence of more middle-class families in developing countries such as China and India will result in a sustained rise of demand for basic products (cooking oil, sugar and gasoline), luxury goods (cars and televisions) and infrastructure (roads, water treatment and power plants).

• Steady global economic growth coupled with population growth against a backdrop of resource scarcity and under-investment in the production of certain commodities will lead to a tight supply-demand situation favouring a sustained rise in commodity prices in the long term.

• Merger and acquisition activities among commodity producers resulting in the consolidation of commodity resources in the hands of a few large companies will boost commodity prices in the long term. At the same time, China buying up commodities, also adds to an already strong demand situation.

In addition, the current global excess liquidity arising from the massive amount of new money printed in the US (ie quantitative easing) coupled with the current record low interest rates in many countries have started to drive commodity prices higher in recent months. These are also part of the broader asset reflation effects that have contributed to the boost in stock and property prices.

We believe this is likely to continue in the medium term as long as quantitative easing remains in place, interest rates remain low or expectations of rising inflation continue.

Commodities versus stocks

The potential for attractive returns is perhaps the most obvious reason for investors’ interest in commodities. This is not the only factor though, as commodities offer investors other significant benefits — a hedge against inflation and event risks, and as a portfolio diversifier.

Commodities are “real assets”, unlike stocks and bonds, which are “financial assets”. Thus, commodities tend to react to changing economic fundamentals in ways that are different from traditional financial assets.

Commodities have enjoyed an almost unbroken bull run from 1999 to mid-2008 while equities experienced a bear market from 2000 to end-2002.

Commodities are also one of the few asset classes that tend to benefit from rising inflation. As the demand for goods and services increases, the price of those goods and services usually rises as well, as do the prices of the commodities used to produce them.

Because commodity prices usually rise when inflation is accelerating, investing in commodities may provide portfolios with a hedge against inflation.
In contrast, stocks and bonds tend to perform better when the rate of inflation is stable or slowing (ie disinflation).

This was the case in the 1990s (see chart). Faster inflation lowers the value of future cash flows paid by stocks and bonds as those future dollars will be able to buy fewer goods and services than they would today.

Commodities also offer investors a hedge against event risk, or the risk of a financial crisis, war or geopolitical event that could cause other asset prices to fall.

Commodity returns have historically displayed low correlation to equity returns. When equities perform well, commodities tend to underperform and vice versa.

As such, adding commodities to an investment portfolio helps to smooth the returns of the portfolio, resulting in less volatile returns. Such a portfolio should also provide a higher level of return for every unit of risk taken.

While the benefits of commodities may be substantial, the asset class is not without risks. Commodity returns tend to be as volatile as equity returns, potentially resulting in periods of underperformance.

The correlation of commodity returns to equity returns has also increased in recent years as a result of a liquidity driven rally for both asset classes, and the higher correlation has the effect of negating some of the benefits of commodities as a portfolio diversifier.

Investors’ commodity investment strategy
Capturing the full benefits of commodity exposure has been a challenge for investors in the past. Investing in physical commodities — a barrel of oil, a herd of cattle or a bushel of wheat is impractical, so investors have tended to seek commodity exposure either by purchasing commodity-related equities, managed futures or ETFs.

Commodity-related equities may include oil producers, resource mining companies and palm oil producers. However, commodity equities may not necessarily reflect changes in the price of commodities.

For example, if an oil producer has aggressively sold its supply on a forward basis, the producer’s stock price may not fully benefit from a rise in the oil price.

Commodity equity returns can also be affected by the company’s financial structure or the performance of unrelated businesses.

On the flip side, a company is able to provide operating and financial leverage to investors, which enables it to make a higher rate of return on the bottom line for every dollar of additional revenue from higher commodity prices.

This tends to cause a commodity stock to outperform the underlying commodity’s price increases.

Managed futures are funds that invest in exchange traded futures, forwards and options of various commodities, equities, fixed income and currencies. Managed futures take directional long or short positions and as such, could generate positive returns in rising and declining markets.

Managed futures are a convenient way of getting exposure to commodities because they do not require day-to-day active involvement by an investor, and the investment decisions are delegated to an investment manager.

However, if the managed futures also invest in other asset classes outside of commodities, the exposure would not be purely commodities.

ETFs are open-ended exchange-traded investment funds that track the performance of a certain index. There are many commodity-related ETFs tracking different kinds of commodity equities, physical commodities and commodity futures.

The major advantage of investing in ETFs is that investors are able to choose exposure to specific commodities, for example to gold, oil or commodity indices such as the Dow Jones UBS Commodity Index. ETFs are a very cost effective and convenient way of investing in commodities.

Commodities have become an important and attractive asset class which complement equities and fixed income in a portfolio for the following reasons — commodity prices in general and in the long run are likely to be on an upward trajectory; commodities are not only an effective hedge against inflation and event risks, they also assist in smoothening out portfolio returns and increase a portfolio’s risk-adjusted returns.

Any serious investors, in our opinion, certainly should not ignore including commodity investments in their portfolio.

Alan Inn is the co-head of CIMB Private Banking — Malaysia’s only full fledged private bank — and author of several published articles.