Make a profit with commodities

Next time you have a cup of coffee, eat a bowl of cereal, or fill up your car with petrol, it's worth considering that you are helping to fuel one of the most remarkable boom areas in the world of investments: commodities.

Over the past decade this sector has enjoyed phenomenal success because the supply of products such as sugar, coffee beans, wheat, and even crude oil has failed to keep pace with the increase in global demand.

This extraordinary imbalance has triggered a 'bull run' in these commodities, which is likely to last for many years and make canny investors a lot of money, says Jim Rogers, author of Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market.
"It's the only area I know where the fundamentals are still improving, he says. "It's a major asset class, which offers wonderful opportunities to make money. This has always been the case, and probably always will be."

To back up his argument he points out that there haven't been any major oil discoveries for more than 40 years and that food stocks are the lowest they've been in decades, despite the fact that many farmers have not been able to get loans for fertiliser.

However, you need to have a thorough understanding of these investments before getting involved.

What are they?
Commodities are best defined as 'primary products' or 'raw materials'. In investment terms, there are 'hard commodities' – such as oil, metals and coal – and 'soft commodities', which include the likes of wheat, coffee and soybeans.

Prices have risen sharply, as the sector has emerged from a long bear market, demand has risen across the world and political instability has continued as a constant concern.

The demand from China in particular has been a major driver of growth, and the £375 billion economic stimulus package unveiled by its government in November 2008 has given observers reason to believe this trend is set to continue.

But although commodities may sound like the perfect investment, they're certainly not for the faint-hearted, as Philip Scott, author of The Commodities Investor, warns. They are notoriously unpredictable assets, he says, and need to be approached with extreme caution.

"There are potentially massive gains to be made, but investors need to accept it's going to be a very volatile ride along the way, Scott adds. "Anyone getting involved needs to have an investment time horizon of at least five years – if not 10."

Lurking dangers

The past year has graphically illustrated the potential risks. Towards the back end of 2008 the ongoing stockmarket slump wiped up to 60% off the value of resources funds, metals and agricultural commodities.

It wasn't so much a problem with the sector as such, as a worldwide aversion to risk on the back of the financial crisis, points out Mark Dampier, head of research at Hargreaves Lansdown. "Anything deemed even the slightest bit risky just plummeted in value, he says. "Emerging markets blew up dramatically, as did oil and other commodities."

The subsequent recovery – partly fuelled by the Chinese stimulus package – has meant that investors who held their nerve will have clawed back much of their losses, but the experience still served as a timely reminder of the potential risks.

Take the example of oil: it was at almost $150 a barrel during the summer of 2008, but had plunged to below $70 by the following summer on the back of ongoing concerns about the global economy. This is volatility on a truly massive scale.

More recently, sugar has rocketed in price due to poor weather in India. Frances Hudson, a global thematic strategist at Standard Life Investments, adds: "The talk is that its price could climb as much as 80%, just because of supply shortages."

What to think about
Commodity prices can be affected by an almost endless stream of factors. As well as general demand, there's the success of individual crops, potential political instability within certain countries, and broader global economic factors.

"People looking to invest may have only read about the gains, but it's important they don't stick all their eggs in one basket," adds Scott.
The amount of exposure will depend on your tolerance to risk, says Darius McDermott, managing director of Chelsea Financial Services. You need to make sure you understand what you're buying and appreciate you're taking a gamble. "Generally, commodities should only make up between 5% and 10% of someone's portfolio," he says.
Even experienced fund managers are cautious when it comes to commodities. Charlie Morris, manager of HSBC Absolute Return Service at HSBC Global Asset Management, for example, was bearish on soft commodities in late 2008, but has softened his stance.

"I'm no longer bearish – but I'm not bullish either, he says. "Although I quite like the idea of owning commodities and found them fascinating when they offered something different, the fact is they now have the same volatility as everything else."

Although he doesn't think commodities are expensive – and points out their values have barely risen since inflation pushed them up in the early 1970s – he doesn't believe they will be at the forefront of the economic recovery.

The only part of this area to which he has exposure is gold, which he likes because it acts as a diversifier in portfolios. Its price may have stopped rising recently because of the equity rally, he says, but at some stage it will take off again.

Commodities are clearly not straightforward, so how can private investors get involved? Should they buy into individual companies or are there more suitable investment products available on the market?

Accessing the market

Essentially, there are four ways you can access the sector: through individual companies or an investment fund; via an exchange traded fund (ETF); or through some form of structured product.
There is no shortage of companies involved in this area, whether you want exposure to oil, via one of the majors such as Shell, or to the activities of mining companies like Xstrata and Rio Tinto.

However, the value of your investment will be totally dependent on the fortunes of the stocks you have bought. If you haven't got much experience of the markets, therefore, it might be worth opting to spread your risk a little wider.

One answer could be an investment fund, which may directly hold the underlying commodities but is far more likely to invest in the shares of companies that are actually involved in one or more of the commodity sub-sectors, such as mining.

Geoff Penrice, a senior financial adviser with Honister Partners, suggests that if you take a long-term view and are not too phased by volatility, you could find that a straightforward unit trust is perfectly adequate for your needs.

"The combination of the increasing industrialisation of developing economies and limited resources means commodities are a good long-term bet," he adds. "But it's harder to predict the short and medium term direction of prices."

The rather erratic performance of natural resources funds over the past few years illustrates his point. While it's easy to be seduced by the long-term figures, the shorter-term statistics tell a different story.

For example, anyone who had invested £1,000 into the JP Morgan Natural Resources fund in August 1999 would have made more than £5,000 in profit as it has since risen by a whopping 524% (to August 2009).
However, over the past year the same portfolio is down 5.46%, according to Morningstar figures compiled to 10 August 2009. Although not as bad as the 12.25% fall of the average UK All Companies fund, it's a loss all the same.

Another option is ETFs. Although these can be linked to a specific commodity index, products are increasingly becoming available that are linked to the actual physical commodities themselves.

ETFs are certainly gaining in popularity. Investor inflows into exchange traded commodities offered by ETF Securities saw assets under management up by more than $6 billion to $12 billion during the first half of 2009.

While gold and oil enjoyed the largest investor demand over the entire period, the last two months saw increased enthusiasm for areas such as natural gas, industrial metals and agriculture.

According to Nicholas Brooks, head of research and investment strategy at ETF Securities, demand for commodities started slowly at the beginning of the year due to concerns over the state of global finances, but then started to pick up.
"Medium to long-term investors view commodities as a good asset class to be in because they recognise that demand, particularly from China and other emerging markets, will remain structurally strong for many years, but supply is limited," Brooks says.

It's getting more expensive and difficult to extract a variety of commodities from the ground, so Brooks believes that commodity prices will eventually have to go higher in order to ration demand and encourage innovation.

Finally, there are structured products. These are designed to run for a fixed period and generate a return based on one or more of the commodity indices.

However, there are pros and cons with them, says Andy Gadd, head of research at Lighthouse Group. The upside is that the risk and return characteristics are known from the start – unlike in a unit trust – while investors may also benefit from a guarantee that their original capital will be returned at the end of the investment period.

The downside is that they can be locked in for a given period, which may not be desirable, depending on market conditions, while the reliability of the guarantees largely depends on the creditworthiness of the counterparty involved.

Which option is most suitable will depend on factors such as your individual aims, attitude to risk, investment time horizons, and how the rest of your investment portfolio is constructed.

Mark Dampier is particularly concerned about people inadvertently overdosing on commodity exposure, and points out that quite a lot of mining and oil companies are actually listed in the UK.

"If someone already has investments in emerging markets they need to understand that these will be quite highly correlated with commodities, he says. "They must be careful that they're not adding too much to what they have already."

Future prospects

Looking to the future, there are good reasons – ranging from demographic drivers to infrastructure projects – to be positive about various commodity markets on a medium to longer-term view, suggests Frances Hudson.
"However, in the near term, the case is not nearly as well made, and investors should be warned about various risks," she says.
Nevertheless, Jim Rogers thinks the arguments in favour of having exposure to commodities in the current climate are overwhelming. "We are in a bull market for commodities at the moment, and normally the way to make money in a bull market is to hang on, he explains. "By the time it gets to the end, there will be hysteria and mania. That will be the time to sell – but we're not there yet."