commodities-within-a-portfolio-smart-investing-in-commodities
Articles

Focus on Commodities

Commodities are an integral part of our everyday lives. They are in our smartphones, and every year the average person in Switzerland consumes more than 600 liters of gasoline. But not only do commodities make our day-to-day lives possible, they can generate added value as financial investments. Find out here how you can use commodities effectively in your portfolio.

Commodities used as financial investments in Ancient Greece

Equities enable us to participate in the development of a company. When purchasing bonds, we lend a company capital in order to benefit from interest income in return. But how is it possible to invest in fossil energy sources or different types of metal?

For a long time, the commodity market was organized in such a way that an exclusive contract was concluded between two or more parties to physically deliver a specific commodity at a specified time in the future for a price defined in advance. This procedure dates back to Ancient Greece, where certain agricultural products were traded as forward transactions, to hedge against falling prices as a producer and against rising prices as a consumer.

Then, in the mid-19th century, the Chicago Board of Trade (CBOT) was founded in the US as the first official commodity exchange in the world. Producers and consumers benefited from regulated trading, better market transparency, and greater liquidity. With what became known as commodity futures, which were traded on the exchange, investors too were finally able to include commodities in an investment portfolio, without necessarily having to concern themselves with physical delivery or storage.

625

liters of gasoline are consumed each year by the average person in Switzerland.

Special features of the commodity market

How much does a barrel of oil cost? The price you would have to pay today for physical delivery is called the spot price. If the price of a forward contract for future delivery is lower than the current spot price, we speak of backwardation. This situation arises when what is known as the convenience yield exceeds the storage and financing costs.

Convenience yield can also be regarded as a benefit in the case of physical ownership of a commodity. It increases when the corresponding market is undersupplied. In this case, consumers are willing to pay a premium for immediate delivery, which can make the futures curve steeper. In this market situation, an investor benefits by rolling contracts for delivery in the near future into contracts for delivery in the distant future. This is known as the roll yield, which is captured in the process. The idea is to benefit from the convergence of the lower price of the commodity contract toward the spot price.

Conversely, we speak of contango when the price of a contract for future delivery is higher than the spot price. This situation arises when the market for a commodity is oversupplied. In that case, the storage costs are generally higher than the convenience yield. If an investor rolls the expiring contracts into future contracts in such a situation, roll costs are incurred that have a negative impact on the total return. It is important to take the forward curve structure into account when investing in commodities.

commodities-as-an-investment

Commodities as an investment

(not exhaustive)

Source: Credit Suisse

Investing in commodities adds value to a portfolio

Analyses have shown that the inclusion of commodity investments in existing bond and equity portfolios can improve the risk/return profile of the overall portfolio as some of the return drivers differ from those in the other asset classes.

An obvious example is the change in the quantities being extracted or produced. This has a direct impact on commodity prices, but generally has no significant influence on the equity or bond market. Conversely, interest and exchange rates affect commodity prices. For example, real interest rates represent what are known as opportunity costs for investors and they play an important role in investment decisions.

Commodities show a low or even negative correlation with other asset classes. To some extend they can be used as a protection against inflation. It is advisable to evaluate the inclusion of broadly diversified commodity investments in existing portfolios of stocks and bonds. The high volatility of some individual commodities can be smoothed by means of various commodity investments or indices. With regards to the commodity indices it is important to keep in mind that the weighting of each commodity position as well as the rolling-mechanism are both important components to achieve returns.