COMMODITIES: THE MISUNDERSTOOD ASSET CLASS

A commodity can be defined as a tangible asset that is typically homogenous in nature. Commodities cover a wide range of goods inclusive of agricultural products, metals and energy. Investors normally separate commodities into 2 broad categories, “soft” and “hard”.

“Soft” commodities: Typically grown, like agricultural products or livestock and thus are subjected to significant short term volatility including products such as cocoa, coffee and sugar. Wilmar International Ltd (SGX: F34) would belong to such a group.

“Hard” Commodities: Typically natural resources that have to be mined or extracted like gold, aluminium and crude oil. Some examples include newly listed AsiaPhos Ltd (SGX: 5WV), an explorer and miner of phosphate as well as LionGold (SGX: A78), the gold company that had been under the spotlight.

How can a commodity investment help in your portfolio?

The main characteristics that encourage the use of commodities would include:

1. Portfolio risk diversifier
2. Inflation hedge

Since supply and demand conditions of commodities are determined by different economic fundamentals from those affecting stocks and bonds, commodity prices are expected to be sensitive to the business cycle but tend to have little correlation with stocks and bonds.

One such period includes times of financial and economic distress where commodity prices tend to rise, potentially providing valuable diversification services to the overall portfolio. There’s also historical evidence which suggests that most commodity indices provide diversification advantages to stock and bond investments primarily during periods of unexpected change in inflation.

How to invest in commodities?

Direct investment

Cash purchase of the physical commodities which has the highest diversification and inflation hedge effect but may not be a feasible option for retail investors due to actual possession and storage of the commodities.

Another method would be through derivatives such as futures for a pure-play on the underlying.

Indirect Investment

Involves an indirect claim on commodities, an example of such would be equity holdings with their underlying operations in the production of commodities. This would be the principal means that most investors used to obtain exposure to commodities. Singapore is home to some of the largest commodity houses in the east collectively termed as “NOW” which is an acronym for Noble Group Ltd (SGX: N21), Olam International Ltd (SGX: O32) and Wilmar International Ltd.

But there’s increasing evidence that commodity-linked investments do not provide an effective exposure to underlying commodity price changes as these companies hedge part of their commodity risks.

Value In Action

A common debate would be the issue of whether commodities represent a separate asset class. But instead the question should be “Are commodity investments appropriate for the investor?”

Another point to note would be that not all commodities are born equal; suitability depends on the type of commodity under consideration.

 

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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Cheong Mun Hong’s personal capacity and do not in any way represent those of his employer and other related entities. Cheong Mun Hong is a shareholder of Wilmar International Ltd.

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