Understanding Investment Instruments: Commodities

|     Standard Chartered Bank     |

 

COMMODITIES are an integral part of our everyday lives. Investors seeking a shield against inflation and an effective means of portfolio diversification have often consider this asset class. But what are commodities, and why should you consider investing in them?

What are commodities?

Commodities are for the most part raw materials, which are processed to be consumed or resold. As basic resources, they are an integral part of our everyday lives. For example, the ring on your finger could be made of gold or silver; your breakfast of a sandwich and jam is made from flour derived from wheat and the petrol fuelling your car is oil – all these are commodities.

Commodities can be divided into four main categories:

  • Precious metals, for example gold, platinum, silver
  • Base metals, for example aluminium, copper, tin
  • Energy, for example oil, coal, gasoline
  • Agricultural products, for example wheat, coffee, cotton

Why invest in commodities?

Increased demand

Strong economic growth shown in previous years in emerging markets such as China and India has created increased demand for oil, steel and other commodities. To illustrate the economic growth and the potential of these countries, compare their GDP and GDP per capita in 2013. GDP means gross domestic product and is the total value of goods and services produced in a country in a year. GDP per capita is the total GDP divided by the number of people in the country.

In April 2013, China was ranked second with a GDP of USD11,212 billion whereas India was ranked seventh with a GDP of USD2,308 billion. Per capita GDP of China is USD7,572, 80th position in world and 18th in Asia. India’s GDP per capita is around of USD1,626. India’s rank in world and Asia is 144 and 34, respectively.

The GDP rankings reflect the large scale of China and India in the world economy and the relative lower rankings of GDP per capita illustrate their potential for continued growth, and consequently their potential demand for commodities.

Limited supply

The commodity supply chain is restricted from an economic phenomenon known as ‘natural barriers to entry’ such as the high capital influx required to establish infrastructure, for example, new mines and refineries. Low prices through the 1990s and early 2000s discouraged investment and as a result, the markets were not able to quickly adjust to the booming demand in China, India and the Middle East. Consequently, inventories of many commodities are low with a limited number of new projects coming on stream.

Diversification of your investment portfolio

Commodities are viewed as a powerful tool for diversifying risk in an investor’s portfolio. Historically they have a low or even negative correlation with stocks and bonds. In other words, when stocks and bonds fall in price, commodities tend to rise.

Shield against inflation

Inflation is a rise in the general level of prices over time. Because commodities are physical assets, they tend to rise in line with inflation so that relative purchasing power is maintained. Therefore, investing in commodities can be seen as a shield against inflation.

How to access the commodity markets

Depending on your portfolio, investment strategy and risk profile, there are many ways for investors to access the commodity market.

There are unit trust funds which have commodities as an underlying investment instrument in the fund. You may also want to explore structured deposit products which is essentially a combination of a deposit and an investment product, where the return is dependent on the performance of some underlying financial instrument, in this case commodities.

Is this a good time to invest in commodities?

There is never a ‘best’ time to start in investing in any particular investment instrument. You should instead already have an investment strategy in mind which can be discussed with your financial planner and also a view of the outlook of the underlying investment. A good banker will help you determine your risk appetite and return expectations before helping you with your decision of investment option.

A good rule of thumb is to always educate and strategise yourself on the investment choices you are looking to make. Even if it is a basic Brunei dollar fixed deposit or a more complex unit trust option, having correct, un-biased information as well as your investment strategy in front of you will help you to achieve the best results.

This article is for general information purposes only and while the information in it is believed to be reliable, it has not been independently verified by us. You are advised to exercise your own independent judgement with the contents in this article and seek the advice of your professional advisers if necessary.