The term ‘commodities’ in an investment context is generally used to describe bulk goods traded on an exchange or in a cash market. Types of commodities include the following:
- Crude Oil
- Natural Gas
- Grain, such as corn
- Live Cattle
Investing in commodities: Funds and Futures
One does not need to own a large warehouse in which to store commodities in order to invest in them. Typically, investors use a fund to gain access to a spread of commodities. As fund managers do not wish to take ownership of large consignments of oil or grain, they in turn will invest in financial instruments called “futures”. A future confers the theoretical right to buy the product for a given price at a given date in the future – though in practice futures trades are almost always settled for the cash equivalent value. The future date at which the commodity must be bought or sold is called the maturity date. If the market price of the commodity goes up, the future normally gains in value. Conversely, if the market price of the commodity goes down, the future normally falls in value.
Advantages of commodity investment
- Commodities can deliver high returns.
- They can protect against periods of high inflation.
- They can provide diversification within a portfolio.
- Given the world’s limited resources and continued emerging markets growth, some argue that a sharp future rise in the price of most commodities is inevitable.
Disadvantages of commodity investment
- Commodities are very high risk as they can fall very sharply in value.
- They are closely correlated to global economic growth and so may fall sharply in value during global economic slowdowns. This can effectively cancel their usefulness as a diversifier.
- Since commodity investments are normally made via futures, the return is not simply related to the current market price of the commodity.
Source of returns from commodities
It is commonly believed that commodity returns are directly related to movements in the current market price of the commodity concerned. However, because commodity investment typically involves futures, the current market price is only one determinant of profit or loss, and it is often not even the main one. The following factors also play a part in investment returns:
- Currency – most commodities are denominated in dollars, so a falling dollar may impact on returns while a rising dollar may increase returns.
- Cash yield – most commodities deliver a yield related to short term interest rates.
- Rolling yield – historically the rolling yield has had a greater long term effect on returns than the current market price.
Because commodity fund managers never wish to own barrels of oil or herds of cattle, they use futures to take advantage of price movements in the underlying commodity. If the holder of the futures does not want to purchase and physically own the commodity, the futures must be sold or settled for cash before the maturity date. Fund managers will often settle futures before they expire and replace them with futures that have a later maturity date.
This trade typically takes place on a monthly basis, as fund managers usually like to hold short-term futures because of their close correlation to the current market price. However the trade itself usually results in a gain or loss. This gain or loss is known as the ‘rolling yield’ because it derives from fund managers rolling over futures contracts.
There have been historic periods when the rolling yield provided a very significant addition to returns, when compared to the yield on bonds or equities. However the disadvantage of the rolling yield on commodities is that it can turn negative. This essentially cannot happen with the yield on most other types of investments – for example, whatever happens to the price of a share, the dividend yield from a share can never be negative.
Mercer's view on commodities
Commodities may have a role to play in a portfolio as a diversifier, but due to the level of risk their role should be limited – probably to a single digit percentage. An exception to this would be for high risk investors that have a specific interest in commodity investing.
Other ways of accessing commodity markets
Those that are interested in investing in commodities and who don’t like the idea of using funds that invest in futures contracts might wish to consider the following:
- Investments in companies that extract and sell commodities, such as oil exploration companies or mining firms, may indirectly be able to benefit from any increase in commodity prices - however, they may also be subject to general swings in stock markets.
- Due to their high value, precious metals such as gold and silver can be purchased in physical form as coins or as bars and stored in a vault, bank or safe.
The direct investor should remember that all forms of commodity investment are high risk.