The challenges of investing in raw materials
As well as the portfolio diversification benefits that commodities can add to holdings of traditional stocks and bonds, they can also have speculative appeal.
In general, commodity prices rise in an inflationary environment, which is why this asset class has been receiving more attention recently. China avoided a hard landing last year and the ‘animal spirits’ have awoken in the US, causing the Fed to raise interest rates.
In the aftermath of the financial crisis, the so-called ‘commodities super cycle’ that was driven by the huge growth in the Chinese economy meant that an investment in a diversified basket of commodities would have delivered excellent returns. However, this long-term performance includes periods of extreme short-term volatility that can affect individual commodities.
Investors should be cautious of investing in individual commodities, particularly on a short-term basis. It can be tempting to buy an exchange-traded product that offers exposure to, say, copper prices because you’ve heard that demand may be increasing. But be prepared for a volatile ride.
In 2002, a London-based hedge fund manager earned the nickname ‘Chocfinger’ after stockpiling 15% of the world's cocoa supply and generating a huge profit (figure 3). He tried again in 2010 using the same approach and the fundamentals were on his side — recent harvests had suffered from poor weather and global stockpiles were running low. Yet it is believed this seasoned soft commodities trader may have lost money the second time due to technical market factors and the reaction of other investors.
Figure 3: Bloomberg Cocoa Index Cocoa prices tend to be driven by various supply and demand factors and can also be influenced by the behaviour of large investors, as they were in 2002 and 2010.
While extreme, this story highlights the challenges of investing in commodity markets. This is further complicated by the fact that unless you have access to storage facilities and can accept physical delivery, the most straightforward way to gain exposure is through an investment vehicle, such as an exchange-traded product or structured note. Many are cheap and liquid, but it’s important to understand what you are buying.
For example, some gold exchange-traded funds track the spot price closely because they are backed by actual bullion, which is stored in secure vaults. Other products use synthetic derivatives, such as futures contracts. However, because commodity markets are complicated, your investment can fall in value even if the price of the underlying commodity has risen.
For example, a problem can occur if there is a large difference between spot prices and the futures price when it is time to roll forward the derivatives contract. That is because commodity markets tend to exist in one of two states. They are said to be in contango when the forward price of a futures contract is above the expected future spot price or backwardation, which is essentially the opposite.
Commodity companies are also risky
The mainstream route to gain exposure to commodities is through the stock market by buying the shares of mining or energy companies. However, there can be problems with corporate governance and unstable political regimes in the countries in which many of these firms operate. Single commodity companies can generate huge returns, but more often lead to spectacular losses — it's the nature of the industry.
Even with the global diversified mining companies, your investment can be undermined by an unforeseen problem in a particular mine or commodity market as well as more general risks, such as management quality and underlying equity market conditions.
Private investors should also think carefully about the tax treatment of any commodity funds. For example, investing through an offshore vehicle is likely to result in an income tax liability on any profits, which would be as much as 40% or 45% for higher rate taxpayers, and is therefore inefficient.
With interest rates in the UK firmly anchored below 1% and unlikely to rise higher any time soon, attention has turned to finding ways to beat inflation. Speculative investments in commodity markets can sound appealing, but we believe a patient multi-asset approach is the best way to grow and protect wealth over the long term.