COMMODITIES
Commodities are an important aspect of most people’s daily life. A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Traditional examples of commodities include grains, gold, beef, oil, and natural gas.
For investors, commodities can be an important way to diversify their portfolio beyond traditional securities. Because the prices of commodities tend to move in opposition to stocks, some investors also rely on commodities during periods of market volatility.
In the past, commodities trading required significant amounts of time, money, and expertise, and was primarily limited to professional traders. Today, there are more options for participating in the commodity markets.
Trading commodities is an ancient profession with a longer history than the trading of stocks and bonds. The rise of many empires can be directly linked to their ability to create complex trading systems and facilitate the exchange of commodities.
In modern times, commodities are still exchanged throughout the world. A commodities exchange refers both to a physical location where the trading of commodities takes place and to legal entities that have been formed in order to enforce the rules for the trading of standardized commodity contracts and related investment products.
Commodities are products or goods like metals, food, energy etc. that we use in our day to day lives. Commodities are tradable in nature i.e. they can be bought and sold freely.
The four major types of commodities are:
Metals – Gold, Silver, Platinum, Copper etc.
Energy – Crude oil, Gasoline, Heating gas etc.
Agriculture – Wheat, Rice, Cocoa, Ragi etc.
Livestock & Meat – Eggs, Cattle etc.
Commodity trading has been happening in India since ancient times; however, poor government policies, fragmented markets and foreign invasions reduced its popularity.
But with the introduction of exchanges like MCX and NCDEX commodity trading in India is regaining its importance and popularity.
To start commodity trading in India, you need the following things:
The best way to invest in commodities is through commodity futures. Commodity futures is a contract to buy or sell a specific commodity at an agreed price on a future date. Futures are available for every commodity listed on the exchanges like MCX.
Commodity trading is generally used to hedge prices to prevent losses related to substantial price swings in essential commodities. Commodity trading is considered to be risky, so generally only experienced traders and investors try their hands at commodity trading.
But with adequate guidance and a good commodity broker like Samco, even beginners can create wealth in commodity trading in India.
Benchmarks for Broad Commodity Investing
Benchmarking your portfolio performance is crucial because it allows you to gauge your risk tolerance and expectations for return. More importantly, benchmarking provides a basis for a comparison of your portfolio performance with the rest of the market.
For commodities, the S&P GSCI Total Return Index is considered a broad commodity index and a good benchmark. It holds all futures contracts for commodities such as oil, wheat, corn, aluminum, live cattle, and gold.1
The S&P GSCI is a production-weighted index based on the significance of each commodity in the global economy, or the commodities that are produced in greater quantities, so it is a better gauge of their value in the market place similar to the market-cap-weighted indexes for equities.2 The index is considered more representative of the commodity market compared to similar indexes.
Why Commodities Add Value
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 a perfect linear relationship, the correlation coefficient will be 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, the correlation coefficient will be -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, U.S. 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.3
Commodities can and have offered superior returns, but they still are one of the more volatile asset classes available. They 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, the overall portfolio risk decreases due to the negative correlation.
For the decade 2011 through 2020, the annual performance of the S&P GSCI has been negative in seven out of ten years. Therefore, some investors have questioned the value of commodities in their portfolios and if commodities could continue to decline in the future.4
How Volatile Are Different Commodities
Supply-and-demand dynamics are the main reason commodity prices change. When there’s a big harvest of a certain crop, its price usually goes down, while drought conditions can make prices rise from fears that future supplies will be smaller than expected. Similarly, when the weather is cold, demand for natural gas for heating purposes often makes prices rise, while a warm spell during the winter months can depress prices.
Because the supply and demand characteristics change frequently, volatility in commodities tends to be higher than for stocks, bonds, and other types of assets. Some commodities show more stability than others, such as gold, which also serves as a reserve asset for central banks to buffer against volatility. Yet even gold becomes volatile sometimes, and other commodities tend to switch between stable and volatile conditions depending on market dynamics.
The History of Commodity Trading
People have traded various commodity goods for millennia. The earliest formal commodities exchanges are among those in Amsterdam in the 16th century and Osaka, Japan, in the 17th century.56 Only in the mid-19th century did commodity futures trading begin at the Chicago Board of Trade and the predecessor to what eventually became known as the New York Mercantile Exchange.7
Many early commodities trading markets were the result of producers coming together with a common interest. By pooling resources, producers could ensure orderly markets and avoid cutthroat competition. Early on, many commodity trading venues focused on single goods, but over time, these markets aggregated to become broader-based commodities trading markets with a variety of goods in the same place.
How to Invest in Commodities
There are four ways to invest in commodities:
- Investing directly in the commodity.
- Using commodity futures contracts to invest.
- Buying shares of exchange-traded funds (ETFs) that specialize in commodities.
- Buying shares of stock in companies that produce commodities.
Direct Investment
Investing directly in a commodity requires acquiring it and storing it. Selling a commodity means finding a buyer and handling delivery logistics. This might be doable in the case of metal commodities and bars or coins, but bushels of corn or barrels of crude oil are more complicated.
Futures
Commodity futures contracts offer direct exposure to changes in commodity prices. Certain ETFs also offer commodity exposure. If you would rather invest in the stock market, you can trade stock in companies that produce a given commodity.
Commodity futures contracts require the investor to buy or sell a certain amount of a given commodity at a specific time in the future at a given price. To trade futures, investors require a brokerage account or a stockbroker who offers futures trading.
When prices of a commodity rise, the value of a buyer’s contract goes up while the seller suffers a loss. Conversely, when the price of a commodity goes down, the seller of the futures contract profits at the expense of the buyer.
Futures contracts are designed for the major companies in the respective commodity industry. One gold contract could require buying 100 troy ounces of gold, which could be a $150,000 commitment, which is more exposure than the average investor wants in their portfolios.8
ETFs
Most individual investors choose ETFs with commodity exposure. Some commodity ETFs buy the physical commodities and then offer shares to investors that represent a certain amount of a particular good.
Some commodity ETFs use futures contracts. However, futures prices take into account the storage costs of a given commodity. Therefore, a commodity that costs a lot to store might not show gains even if the spot price of the commodity itself rises.
Commodities-Related Stocks
Investors can also buy shares of the companies that produce commodities. For example, companies that extract crude oil and natural gas or companies that grow crops and sell them to food producers. Investors in commodity stocks know that a company’s value will not necessarily reflect the price of the commodity it produces.
What is most important is how much of the commodity the company produces over time. The price of a stock can plummet if a company does not produce what the investors have anticipated.
Why Are Commodities Considered an Inflation Hedge?
Inflation is a general rise in prices. Commodities tend to be inputs into manufacturing processes or consumed by households and businesses. As a result, when prices rise in general, so should commodities. Traditionally, gold has been the exemplar inflation-hedge commodity.
How Do Commodities Diversify a Portfolio?
Portfolio diversification occurs when uncorrelated risky assets are added to it. Because commodities, on average, have low or negative correlations with stocks and other asset classes, they can provide some diversification.
What Are Hard vs. Soft Commodities?
Hard commodities are usually classified as those that are mined or extracted from the earth. These can include metals, ore, and petroleum products. Soft commodities instead refer to those that are grown, such as agricultural products.
What Percentage of My Portfolio Should Be in Commodities?
Experts recommend around 5-10% of a portfolio be allocated to a mix of commodities. Those with a lower risk tolerance may consider a smaller allocation.
