It has long been recognised that an investment in commodities can offer several benefits to a portfolio, including negative correlation to stocks and bonds and historically higher index returns.
The fundamentals supporting the commodity price rise so far have been structural. The recent performance has not only been driven by the strong demand for commodities from Asia and particularly China, but also by the severe supply-side capacity constraints that many commodity sectors are facing. This capacity constraint has been fuelled by the lack of investment over the 1990s in the production and transport of many commodities.
Having once been a speculative vehicle for high risk-takers, the commodity market is maturing as an opportunity for institutional investors. That appetite is driven not only by the expectations of potential equity-like returns, but also by the diversification potential of commodities. It is clear that commodity markets behave differently from those of bonds and equities. So for institutional investors with large bond and equity holdings, commodities are a great diversifying agent that may help to reduce the risk profile of the portfolio as a whole.
Commodities also provide a good hedge against macro shocks and may not be adversely affected by inflationary pressures. Unlike traditional asset classes, commodities generally enjoy a positive relationship with inflation and it is often the case that shocks to equity or bond markets cause them to move in opposite directions.
How do you invest in commodities? There are three main ways of gaining commodities exposure in your portfolio:
>> Passively: an exposure to a commodities index, such as the Goldman Sachs Commodities Index (GSCI) or Dow Jones-AIG Commodities Index.
>> Enhanced Index: investing in a strategy which seeks to generate a return above the index through a 'semi-active' approach
>> Active: this often involves the trading of individual commodities or sub-sectors with tactical asset allocation between types of commodities.
There are advantages and disadvantages to each approach but what it really comes down to is your desired level of involvement and the types of investment instruments you feel comfortable with.
Often a good way of putting your toe in the water is with a pooled vehicle where all the buying and selling of the commodities exposure, the associated cash management and reporting is contained within the fund
structure. This allows you time to gain confidence in the asset class without being bogged down in the operations and accounting aspects of investing in something new.