This fact sheet provides additional information to help with understanding the investment, tax and other financial planning concepts that we have discussed with you or included in your Statement of Advice.
Please contact your adviser if there is any aspect on which you need further information or clarification.
What are Commodities?
A wide variety of marketable items or goods traded across global markets are known as Commodities.
Commodities are ‘homogenous’ assets, which means that they do not vary to a large degree from producer to producer.
Instead, they conform to a standard measurement and grade of quality, e.g. a barrel of oil or a tonne of iron ore.
In financial markets, to be traded as a ‘commodity’, the commodity must also be:
- Traded in bulk
- Have price variations significant enough to be attractive for investors
Examples of traded commodities include:
- Energy, such as crude oil and gas
- Base metals, such as copper
- Precious metals, such as gold, silver and platinum
- Agricultural commodities, commonly known as Softs, such as wheat and soybeans
- Livestock, such as cattle
- Bulks, such as iron ore
Commodity prices can be volatile and fluctuate substantially when a natural disaster, such as a hurricane or an earthquake, affects their supply or production. However, not all commodities exhibit the same characteristics. Investors often view gold and other precious metals as a store of value and safe havens during times of crisis or uncertainty.
Investing in Commodities
If used as a financial investment, commodities other than precious metals are usually not bought/sold directly. Investors instead invest in a security or derivative that references the commodity price. An exception is precious metals, where direct access is available to the investor in non-bulk quantities e.g. gold bars and coins.
There are a variety of financial instruments available, including structured products, derivatives and mutual funds, and these differ in their advantages/disadvantages from direct investment.
- Futures, forwards, options and structured products. These are advanced financial constructs with very specific properties and risks. Investing in these products requires the corresponding knowledge.
- Mutual funds. Funds are collective investments that pool money from multiple investors for collective investment. Funds are available for any type of investment. Risks and properties vary, and a basic knowledge of funds is required.
- Precious metal accounts. Similar to handling foreign currencies.
- Physical delivery. Buying and selling the physical entities such as bars, coins. If not delivered physically to the investor, they are usually kept in custody with a bank, i.e. custody fees do apply.
- Commodity Indices. When investing indirectly into commodities, corresponding products (e.g. funds) are often based on commodity indices or commodity futures due to their advantages regarding accessibility and traceability.
Commodity Indices
There are a number of available indices that track the commodity markets, constructed and maintained with reference to either composition (component weights) or roll strategies.
Composition (Component Weights)
Determination of which components (e.g. agriculture, oil, wheat) and at what ratio they are included in the index calculation.
An example for a calculation may be to choose a product-based index that is oriented on production volumes and liquidity.
Roll Strategies
An index based on a roll strategy uses futures to track the price of the target commodity, with a focus on minimising the negative effects of 'roll costs'.
It is common for commodities to trade in 'contango', where the futures price is higher than the current or 'spot' price. If exposure is gained by continually investing in the 1 month futures contract, losses are incurred as the contract approaches expiry and the price converges with the spot price. The contract is then rolled over, effectively selling at the lower spot price and buying the 1 month future contract at a higher price.
This difference is the 'roll cost', which can be a significant drag on returns and cause a performance gap between investment in the physical commodity and investing using futures. A roll strategy will aim to minimise this roll cost.
Key Features of Commodities
When contemplating an investment in Commodities, investors should consider the following key features.
Investment Horizon
Medium – Long Term
Return Expectation
Capital gain
Market Expectation
Suitable for expectations of rising, flat or falling market conditions, depending on the commodity type and strategy employed.
For example, copper has a strong correlation with economic growth and positive equity market performance, while gold tends to act as a hedge against adverse shocks to the economy.
Maximum Gain
The maximum gain is unlimited.
Maximum Loss
The maximum possible loss is that of the capital invested.
Profit / Loss
Returns on commodities are difficult to estimate, as they are often directly linked to regional or global industrial supply/demand. Other factors that can materially affect the price of commodities include regulatory changes, and movements in interest rates and exchange rates.
Trading Process
Futures exchanges host the bulk of the trading in standardised commodity contracts. Supply and demand determine the value of a contract for a specific commodity, along with interest rates and the cost of storage for the period between trade date and settlement date.
Trading Costs
Buying and selling commodities create explicit and implicit costs for the investor. Brokers and banks charge transaction fees for their services depending on the type of asset, the market place and transaction volume. Minimum fees per transactions can apply. The exchange may also charge a commission, and in some countries, governments add stamp duties or other taxes to the total cost.
Investors should also be mindful of implicit costs, mainly bid/offer spreads, on traded commodities, and the associated currency conversion. The bid/offer spread is the gap between the highest price a buyer is willing to buy a security and the lowest price that a seller is willing to sell that same security. A spread is wide (large) or narrow (small) and reflects liquidity in the market for a particular security.
Advantages and Disadvantages
Advantages
- Inflation protection
- Portfolio diversification with alternate return drivers
Disadvantages
- Cost of safe and secure storage (if taking physical delivery)
- Volatility
Risks
Private investors do not usually invest directly in commodities. Therefore investors also carry the specific risks and rewards of the financial product tracking the commodity price, e.g. the fund, structured product or derivative.
These structures and products add their own risk, e.g. manager risk, while allowing greater diversification.
Market Risk
Commodities are the basis for other products and respond differently to the economic cycle than other financial products, such as stocks and bonds.
Commodity prices depend on factors other than supply/demand, including the geopolitical situation, country-specific economic factors, natural influences (e.g. climate, weather) and the nature of the commodity itself.
For example, adverse climate conditions can affect the supply of soft commodities such as wheat. Also, commodities are typically not dispersed equally around the globe. Transport costs, trade tariffs and geopolitical positioning impact both supply and demand for a particular commodity.
Leverage Risk
Commodities are volatile, and using leveraged products to gain exposure amplifies the effect of this volatility on an investor’s equity.
Manager Risk
Suppose an investor gains their commodity exposure by investing with a hedge fund specialising in commodity trading. In that case, the risks are those of the commodity market plus the chance that the manager will stray from their investment objective or fail to meet their long term performance benchmark.
Commodity Risk
Refers to the uncertainty of commodity prices and the effect on direct investors in commodities or investment in companies that rely on commodity inputs, e.g. food manufacturers, oil refineries.
Important Information
Walbrook Wealth Management is a trading name of Barbacane Advisors Pty Ltd (ABN 32 626 694 139; AFSL No. 512465). Barbacane Advisors Pty Ltd is authorised to provide financial services and advice. This post is general information only and is not intended to provide you with financial advice as it does not consider your investment objectives, financial situation or needs, unless expressly indicated otherwise. You should consider whether the information is suitable for your circumstances and where uncertain, seek further professional advice. The author has based this communication on information from sources believed to be reliable at the time of its preparation. Despite our best efforts, no guarantee can be given that all information is accurate, reliable and complete. Any opinions expressed in this email are subject to change without notice, and we are not under any obligation to notify you with changes or updates to these opinions. To the extent permitted by law, we accept no liability for any loss or damage as a result of any reliance on this information.
