Investing in Commodities

Investing in Commodities

With the growing concern of inflation, investors around the world are turning towards commodities as a form of investment strategy. This is because commodities have been known to be a good inflation hedge. Unfortunately, Malaysian retail investors are not too familiar with this alternative investment trend i.e. commodities investment. The perception amongst a majority of investors is that investing in commodities are more suitable for institutional and a niche group of high net worth investors.

At the end of this article, you will be able to identify the different categories of commodities and the importance of having them in your investment portfolio.

What Is There In Commodities?

In general, commodities are tangible assets that are derived from the ground. Commodities are usually categorized into three major groups i.e. agricultural products, energy and metals.

These commodities are the foundation of the global economy and historically, their prices tend to move in different direction than stocks and bonds at various stages of business cycles. Investors find that by adding commodities investment into their portfolios, it will diversify their portfolio risks.

In order to understand how investment in commodities can help to diversify investment risks, we need to understand the factors driving the prices of commodities.

Below are some examples of factors that drive the prices of commodities:

• Global economy

Generally, during strong economic situations, prices are driven up by strong demand. However, commodities defer from other assets in that its prices are affected by overall short-term expectations on the directions of economy. As for the prices of stocks and bonds, it leans more towards long-term expectations on the overall economic situations.

• Supply and demand

When there are limited supply of the commodities and continuous strong demand, its prices will be higher. This is because businesses are willing to bear the cost of holding inventory (such as storage of the commodities and maintenance of warehouses) as long as there is uninterrupted supply. The producers of commodities will also increase production to take the opportunity to enjoy the price hike until the supply and demand graph reaches equilibrium. However, when supply exceeds demand in the market, the prices of commodities will drop, which will cause the production of commodities to be reduced until it balances with the demand graph in the market.

• Storability

Storable commodities such as gold, industrial metal and oil, will show positive correlation with inflation while other non-storable commodities, will have negative correlation with inflation. This implies that those that have positive correlation with inflation are good candidates for protection against inflation since their prices tend to increase with growing inflation.

Based on historical data and from the risk and return characteristics standpoint, if we compare the return and volatility of commodities investment to other asset classes, commodities usually have a modest return with high volatility. Therefore, by itself, it is not a strong choice of investment.

Inflation will usually result in increasing interest rates. This will bring about higher cost of borrowing. Unless a company is able to pass on the increasing cost of business to consumers, inflation will affect the profitability of their business. It leads to lower stock prices. Investors who have made some investment allocation to commodities, especially commodities that play active roles in economic activities and have positive correlation with inflation, would have been able to partially offset the negative impact of disappointing performance of equities through commodities investment.