Tuesday, August 23, 2011

A beginner's guide to investing in commodities - Interactive Investor

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 $1,800 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.

The basics

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."

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