We’ve noticed some excitement in the press around commodities recently. Terms like ‘supercycle’ are being tossed around again – the last supercycle being in the 2000’s where China’s rapid growth drove a huge and sustained increase in the price of the commodities fuelling its expansion.
Much of the recent excitement has to do with rapid gains after last year’s Covid-related slowdown, as well as some current fears of inflation: the received wisdom being that commodities provide an effective inflation hedge in portfolios.
Whether commodities are a good investment or not is a formidable topic and one that’s open to debate. I’m not aiming to rehash the debate fully here, but there are a number of fundamental considerations that should be included in any conversation on this asset class.
How do you invest in commodities?
Investors can gain exposure to commodities either directly, or indirectly.
Direct exposure is via:
- physical investment in the commodity (like buying gold bullion)
- investing in an exchange traded commodity fund
- commodity futures, forwards or other derivatives
Indirect exposure is via:
- investing in commodity-producing companies like gold miners or oil majors
Direct Commodity Investing
While it’s possible to invest in individual commodities, if you’re investing more broadly, you’ll probably be doing so with reference to a commodity index. The best known of these is the Bloomberg Commodity Index, or BCOM that has 23 constituents.
There are other well-known indices too, like the S&P GSCI. While similar to the BCOM in terms of the commodities it represents, it has a much higher weighting to energy at 54%, so is much more exposed to the oil price than BCOM.
Costs
The major drawback from investing directly in commodities is that they don’t produce dividends and they don’t produce income. Moreover, they are costly to transport, store and insure.
These costs either show up directly (for example the fee you pay to hold your gold bullion in a vault and insure it) or indirectly (futures prices on the derivative exchange are usually higher than current prices to factor in storage costs, which results in ‘roll costs’ when shorter dated contracts are replaced over time with longer dated ones).
Quite often when commodity prices are quoted in the press, these costs are ignored, making commodities seem more attractive as investments than they really are.
You can see this quite clearly in the difference between the Bloomberg Commodity Index (BCOM) which does factor in storage and ‘roll’ costs, and the Bloomberg Commodity Spot Index (BCOMSP) which does not.
It’s clear how important it is to factor in costs when investing in commodities (and indeed, in anything else). As of the end of April, spot prices were only 10% off their peak in the Chinese post-financial-crisis-fuelled stimulus highs of 2011.
After factoring in costs, the investible BCOM Index is, however, down almost 50% over the same time period. The same effect can be seen when commodities are rallying. While (uninvestable) spot prices increased almost 70% from March 2020 to April 2021 in dollar terms, the investable BCOM only increased 46%.
Investing in Commodities: Proceed with Caution
So, are commodities a good investment at present? Well, if we are, indeed, in the early foothills of another supercycle, then there could be a lot of money to be made from holding a broad basket of commodities even after factoring in costs.
That said, there is a big difference between ‘trading’, which is short-term in nature, and ‘investing’, which is much more long-term. The lack of yield and significant associated costs do tarnish the attractiveness of commodities as long-term investments.
What can be opportunistically attractive to short term speculators like hedge funds and systematic quant traders isn’t necessarily suitable for more patient strategic investors, who may be better off focusing elsewhere.
Nic Spicer is UK head of investments of PortfolioMetrix
