A beginner's guide to investing in commodities
Commodities are a hot topic at the moment, with prices soaring as other asset classes falter. In August, the price of gold hit a record-breaking $1,900 an ounce, and the price of a barrel of Brent oil - dubbed 'black gold' - is consistently hovering above $100.
Recent stockmarket volatility and increasing UK inflation have driven investors towards tangible assets. Commodities, like much else, are subject to the economies of supply and demand.
When supply falls, as in the case of oil, the price will steadily rise. Likewise, when demand rises, as in the case of gold, the price goes up.
Commodities are physical assets. They include metals like gold and silver, oil and gas, and so-called 'soft' commodities such as wheat, sugar and cocoa beans.Agriculture, which was traditionally hard for investors to access, also comes under the commodities umbrella.
They are often called 'safe havens' as they preserve wealth in a physical way.
"Commodities are often referred to as the 'fifth' asset class, after the conventional investment asset classes of cash, fixed interest securities, equities and property," says Martin Bamford, managing director of IFA Informed Choice.
The sector has little correlation with the stockmarket and currencies, which means if equity markets fall, then the price of commodities won't necessarily plummet.
Bamford adds: "They tend to behave differently to these conventional asset classes, which means they can be very useful for the purposes of diversification within an investment portfolio."
"Investment into precious metals has gained significantly greater visibility over the past decade," says Russ Koesterich, global chief investment strategist at BlackRock's exchange traded fund (ETF) arm, iShares.
"While gold has acted as a store of value for thousands of years, the recent performance of precious metals, their diversification benefits and inflationary concerns have restarted the discussion of this investment category among many institutional and private investors."
Commodity prices have rocketed over the past 10 years, much of their success deriving from the ongoing growth story of the emerging markets. Due to an increasing population - there are now 6.94 billion people in the world, according to the United States Census Bureau - global demand is now much higher, and commodity prices have risen to reflect this.
China, as an example from the emerging markets, has seen GDP growth of around 9% a year, with its consumers richer and more numerous than ever before. They can now afford to use more oil and gas, and consume more expensive food like beef and dairy produce. As a result, prices for these commodities have rocketed.
How to invest
You can invest in commodities physically, by investing in a mining or exploration firm or indirectly through a fund or an investment trust. Investing physically means actually buying and holding the asset, although this comes with storage problems.
In the case of buying a physical asset, gold is typically the most popular, with several bullion firms offering online gold dealing and safe storage of the asset. Buying physical gold coins also offers an easy way to access the metal. The World Gold Council gives details of reputable companies on its website, so always check there first.
"Real direct exposure in commodities usually involves buying physical assets, such as gold coins or bars.
"This can be expensive, with buying and selling costs to consider in addition to the cost of storage and insurance. Investors will also need to ensure they buy the asset at a good price. This can be difficult to achieve, particularly when buying smaller quantities," comments Bamford.
As for other natural resources such as oil and gas, one way to access them is to buy shares in companies, such as BP (BP.), Royal Dutch Shell (RDSB) and Tullow Oil (TLW). The same applies to 'soft' commodity companies, although they are less numerous on the Footsie indices in the UK. However, your investment will be subject to movements in the stockmarket, as well as changes in the price of the commodity.
To spread risk, an investment fund is an easy way to access the sector. They also provide a degree of diversification, as they will invest in a variety of commodities.
Several natural resources funds have posted spectacular results in the wake of soaring gold prices.
BlackRock's Gold & General fund, investing primarily in the shares of gold mining companies, has gained 296% over seven years to 1 August. The group's World Mining investment trust has most of its assets in gold, platinum, silver and diamonds as well as base metals. Its performance is not shabby either - up 316% after seven years.
Evy Hambro, who manages both BlackRock vehicles, puts the outperformance down to a variety of factors, although the increased jewellery demand from the emerging markets will continue to "play a part".
"Demand for jewellery has soared in the developing world, particularly in India and China. Jewellery now accounts for 56% of all gold demand excluding that from the official sector, with Indian imports of gold and silver reported to have risen by a staggering 222% in the past year to May," he says.
The JPMorgan Natural Resources fund, investing in shares of commodity production companies with some exposure to soft commodities, is up 293% over seven years, while the First State Global Resources fund has soared 288% over seven years and is ranked first in the global sector.
Specialist agriculture funds have opened to new investors hoping to capitalise on rising food prices, with the Baring Global Agriculture and First State Global Agribusiness funds up 13 and 20% respectively over the past year to 1 August.
Passive funds have also risen in popularity over the last few years, with ETFs becoming a viable way to access commodities.
Equity-based commodity ETFs will invest in shares of commodity companies through an index such as the FTSE 100 (UKX), whereas exchange traded commodities (ETCs) are instruments that track the future price of the commodity, or a basket of commodities. They can either be physically-backed by the commodity itself, or use swaps with other financial institutions to provide the exposure.
However, as they only track an index such as oil futures, there is little room for manoeuvre. Should the price of the commodity fall, so will the investment, as the ETF will simply track its performance. ETCs also allow investors to 'short' or 'leverage' their investment, allowing investors to either take bets on the price falling, or the price rising.
Investors should be careful here, as although there are potential gains to be made, there could be huge potential losses too.
ETCs are available from Deutsche Bank's ETF arm, db X-trackers; iShares and ETF Securities.
Another avenue to explore is investing in a futures contract of a particular commodity. This investment will track the price of the metal, for example, at a particular point in the future, and are typically limited to large institutional investors who have the resources to take these positions.
While this investment is linked more directly to the price of the metal than commodity equity funds, it might diverge from the current (spot) price of the metal because of the access costs to the future market.
What investors should be aware of
BlackRock's Koesterich highlights four reasons to invest in the sector: portfolio diversification, inflation hedge, being a safe haven and to take a bet on specific industries or regions. However, he says that investors should be aware of whether or not the investment provides exposure to the underlying metal.
In addition, commodities already make up a significant proportion of the FTSE 100. Overall, the oil and gas industry makes up 17% of the index, while basic materials makes up 13% - which translates as a large part of any UK-focused portfolio.
Jason Witcombe, chartered financial planner at Evolve Financial Planning, advises investors to look at their current portfolio carefully before ploughing money mindlessly into the sector, as it's likely a large part will already be invested in commodities, albeit through listed commodity companies.
Also, with a smaller portfolio worth £50,000 or less, such a large percentage will already be invested in the sector so it makes little sense to invest further.
Instead, for beginners with a taste for commodities, Witcombe suggests upping exposure to the emerging markets, as it is here where some real growth can be gained from commodities.
"The commodity sector is even more pronounced in the emerging markets," he says. "A large part of South America's output, for example, is very commodity-driven. Investors can put a little bit extra into emerging market equities, which are heavily weighted towards commodities."
Witcombe counsels against "jumping on the bandwagon" of rising oil prices though. "It's more speculation rather than investment, as there is no reliable return mechanism, which makes them so volatile."
Witcombe also suggests investing in the physical metal or commodity itself, or spreading risk by investing in a fund. He adds: "Keep a good focus on costs. That's why I favour tracker funds. If you are enticed to invest in a commodity fund, there can be up to a 5% initial charge. The more specialist the fund, the more you can expect to pay.
"If 5% is disappearing before you're started, you're on the back foot."
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
The total money value of all the finished goods and services produced in an economy in one year. It includes all consumer and government consumption, government spending and borrowing, investments and exports (minus imports) and is taken as a guide to a nation’s economic health and financial well being. However, some economists feel GDP is inaccurate because it fails to measure the changes in a nation's standard of living, unpaid labour, savings and inflationary price changes (such as housing booms and stockmarket increases).
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
A type of derivative often lumped together with options, but slightly different. The original derivative was a future used by farmers to set the price of their produce in advance before they sowed the seeds so that after the harvest, crops would be sold at the pre-agreed price no matter what the movements of the market. So a future is a contract to buy or sell a fixed quantity of a particular commodity, currency or security (share, bond) for delivery at a fixed date in the future for a fixed price. At the end of a futures contract, the holder is obliged to pay or receive the difference between the price set in the contract and the market price on the expiry date, which can generate massive profits or vast losses.