Investment in Commodities with Futures & Options and ETFs

For most of us, the word ‘commodity’ conjures up the image of rising prices and inflation. However, there is another side to commodities, the investment side!

After the dot-com bubble burst, investments in commodities displayed a significant uptrend. More and more prudent investors are leveraging on the negative relationship between commodities and equities. While India still needs to catch up on this asset class, it is only a matter of time before investments in commodities gain a larger share of the retail investor’s wallet.

Here, we try and de-mystify and provide insights into this asset class so that the investor can take informed decisions.

What are commodities?

Commodities are generic, largely undifferentiated goods that can be processed and resold. In a simplified sense, they are items of value, uniform quality and produced in large quantities by different producers.

Commodities are mainly classified into five key sectors as shown in the accompanying table. These commodities are spread across geographies with Australia, Brazil, South Africa, Indonesia, Malaysia, Philippines, China, India, and Thailand being countries with sizeable resources. Commodities display cyclical behaviour.

And this is how the commodity cycle works — when demand rises, prices shoot up, but when new production comes on stream, prices fall. Usually during commodity bear markets, equities experience a bull market because the raw materials, which producers buy and consume to manufacture goods, comes at a low cost, thereby ensuring higher manufacturing profits.

As a result, inventories begin to peak, which eventually results in supply exceeding demand. This exerts downward pressure on commodity prices. While commodity prices are extremely volatile, price movements follow broad super cycles, which are long periods of rise, generally extending to over 17 years.

Such cycles are mainly driven by demand from the means of urbanisation and industrialisation of a major economy. In last 150 years, the world has been witness to two commodity super cycles. The first one resulted from the industrialisation in the US, dating from the late 1800s to the early 1900s.

The second one started in 1945 and continued up to 1975 driven by the post war reconstruction in Europe and Japan’s economic resurgence. Though the fundamental price trend in a super-cycle is upwards, there are times when prices are detached from demand-supply fundamentals and are very volatile.

The latest cycle started in 1999, since then we have seen commodity prices rising steadily and following the pattern of the beginning of a long-term upward super cycle. This cycle has been driven so far by the world’s fastest growing economy – China and its rising demand for commodities, spurred by industrialization and urbanization.

Other emerging market economies are also contributing to the current super cycle.

Benefits of investing in commodities

Why should an investor consider commodities at all? Well, commodities offer a host of benefits as an asset class-

Hedge against inflation: Commodity prices usually rise with inflation and, thus, show a positive correlation with inflation. Commodities can, therefore, help investors hedge against inflation.

Portfolio diversification: Investing in commodities can help investors diversify their portfolio and, thereby, reduce the risks associated with a portfolio concentrated only in equity. For instance, in the bear market between June 1999 and December 2000, the Rogers International Commodities index rose nearly 68 per cent even as the BSE Sensex fell 2 per cent. Between October 2007 and now, while the Sensex shows a marginal decline, the Rogers Index is up 32 per cent. This shows that commodities can help investors offset losses from equities during bear markets.

Return optimisation: A prudent mix of investing in commodities and equities can help investors achieve optimum returns while reducing the associated risks.

How to invest in commodities

Commodity markets have come a long way since markets operated purely on physical purchase and delivery. Over the years, commodity trading has become sophisticated with standardised contracts and now boasts of futures and options through commodity trading exchanges.

Investors have a plethora of avenues to invest in, which include commodity futures, commodity exchange traded funds (ETFs), commodity stocks and the preferred mutual fund route.

Commodity futures

A commodity futures contract is an agreement between two parties to buy or sell the commodity at a future date at today’s future price. Futures contracts differ from forward contracts in the sense that they are standardised and exchange-traded

Commodity options

These are derivatives products, like a futures contract, but different, in that the risk is limited for the buyer, while profit is unlimited . For the seller, the return is restricted to the premium that the buyers pay to buy an option that gives them the right to buy (call option) or right to sell (put). The seller has an obligation to buy from the put buyer or to sell to the call buyer. In India, commodity options are European style, which can be exercised only upon maturity of the contract. American style options can be exercised any time over the life of a contract.

The Multi-Commodity Exchange of India (MCX) last October launched India’s first commodity options in gold, giving stakeholders a new set of financial instruments to hedge their price risks. NCDEX has started trading in guar options. More commodity options contracts are likely to be launched in agro-commodities and metals are likely in the days to come.

Commodity ETFs

Commodity exchange-traded funds (ETFs) invest in physical commodities such as agricultural goods, natural resources and precious metals. A commodity ETF may be focused on a single commodity and hold it in physical storage or may invest in futures contracts. Other commodity ETFs look to track the performance of a commodity index that includes dozens of individual commodities through a combination of physical storage and derivatives positions.

Mutual funds

Some mutual funds offer an avenue for investors to take advantage of the investment potential of commodities. Today, there are a host of mutual funds that invest in commodity stocks or in exchange-traded funds or fund of funds route.

Commodity stocks

Investing in commodity stocks is another option. In this case, investors can purchase stocks of those companies that are engaged directly or indirectly with the business of manufacturing commodities. Commodity stocks-focused mutual funds are an interesting way of diversifying portfolio beyond bonds and stocks. These funds invest in stocks belonging to commodity sectors or fund of funds, which invest in other commodity funds.

These funds offer the conventional benefits of mutual fund investing, which include diversification, using the expertise of a fund manager, affordability (since investors can opt for systematic investment plan) and convenience. They also help lay investors avoid the hassle of trying to understand and time commodity markets, by using the services of fund managers and, thereby, capitalising on the potential of this emerging asset class.