Trading in commodities is hardly a new concept. Before the invention of currency, people all over used to barter for goods and services from Europe to Asia. During the exploration of the New World, European traders realised paper currency was worthless to the natives and beaver pelts became the de facto currency. Even in modern times, especially during economic downturns, certain commodities replaced cash mainly due to the fact they were real assets. Though the origins of commodity futures can be traced back to Japan in the 1700s, the Chicago Board of Trade (CBOT) is recognised as the first organised exchange trading in commodities in 1848. Even in India, cotton futures were traded
in Mumbai (then Bombay) in 1870, which later went on to include grain, jute and bullion.Why do people invest in commodities?
To understand the reason for investing in commodities, one needs to remember that commodities are closely linked to inflation. Commodities are raw materials used to manufacture goods and thereby are related to the primary economy. Soft commodities are usually agricultural produce like rice, wheat, rubber, cotton etc. Hard commodities refer mainly to mineral resources like gold, silver and crude oil. Commodities are quickly consumed and their prices are linked to the cost of living. Therefore during an inflationary period, the prices of commodities inherently will increase.
Most investors use commodities as a hedge for stock prices. During inflation the value of common stock goes down. While there are various explanations, the most common one is that inflation leads to higher prices and higher interest rates. For companies, borrowing money becomes expensive. Also an increase in interest will lead to a lower earnings per share (EPS) which will affect the company’s share prices.
On the other hand, a small increase in prices will allow investors to profit from commodities if the trade is done profitably. Investing in commodities mainly serves two purposes, acting as an inflationary hedge while having an upside potential.
However, due to the high volume of money and expertise required, institutional investors form the majority in the commodities trade.Can an average investor participate in commodities market?
Yes, an average investor may participate in commodities through a futures contract
. A futures contract is an agreement to buy or sell, in the future, a specific quantity of a commodity at a specific price. An investor can indirectly invest in commodities via mutual funds.
While a mutual fund cannot invest directly in commodities, they can invest in stocks of companies involved in commodity-related industries.
In India, mutual funds invest directly in one commodity-gold. The remaining mutual fund schemes invest in equities of commodity companies or buy units of other funds investing directly in commodities.What are the advantages of investing in a commodity driven mutual fund?
Since mutual fund schemes invest in companies and not the underlying commodity itself, a company with strong fundamentals can possibly give a reasonable return. Leveraging smartly can lead to reasonable amounts of money if you are on the right side of the trade.
An actively managed fund will rely on the expertise of the fund manager who can make a better investment decision than an average investor.What should an investor watch out for?
Due to varying demand and supply, commodities are a volatile market.
As funds invest in companies, the returns depend not only on commodity price changes but also on equity markets and macroeconomic conditions. For instance, an increase in crude oil prices does not necessarily mean the share prices of an oil exploration and production company will increase.
Since commodities are spread over various countries, the funds expose investors to currency, economic and political risks. For instance, if an investor has bought units in a US commodity fund, due to currency fluctuations, they can lose money if the rupee appreciates against the dollar.
The bottom line is that commodity funds provide an avenue for diversification. However the investor needs to perform due diligence of the company the fund invests in and also of the fund’s fee structure to ensure they have maximum returns.
Happy investing!Disclaimer: Mutual Fund investments are subject to market risks, read all scheme related documents carefully