Today investors have tools to invest in commodities from mutual funds to ETFs
The global financial market has become one of the important barometers for the growth of the economies. Each asset class is equally important in the growth of the global economies. Major asset classes include equities, bonds, currencies, and commodities have a distinct contribution to the world economy. In this article, we would be discussing commodities as an asset class and their distinct features in comparison with other asset classes.
The commodity market has evolved significantly from the days of the barter system to the present day of transferring the title of goods through electronic exchanges in the form of forwarding, futures, and options. Today, futures and options contracts can be traded on exchanges around the world on a huge array of metals, energy products, and agricultural products. These standardized contracts enable producers of commodities to offload their price risk to end-users and other financial market participants.
Commodities have given another spectrum of investment tools for traders, arbitrageurs, and hedgers according to their objective of investment or business. Commodities have evolved as an asset class with the development of commodity futures indices and subsequently, investment options that benchmark against these indices. Today investors have tools to invest in commodities from mutual funds to ETFs, covering the wide array from single commodity exposures to sector-based and broad-based commodity exposures.
Commodities are a distinct asset class with returns that are largely independent of stock and bond returns. Therefore, adding broad commodity exposure can help diversify a portfolio of stocks and bonds, potentially lowering the risk of an overall portfolio and boosting returns. Given their impact on consumer goods prices, commodities can also offer a hedge against inflation. It is historically seen that the commodities and other asset classes such as equities and bonds carry an inverse correlation. This characteristic will give an opportunity for investors to have commodities in their portfolio and make their portfolio a balanced one.
Investment in commodities gives three benefits to an investor such as hedge against inflation, diversification with other asset classes, and return potential which is independent of equities and bonds. Since commodities are real assets, they tend to react to changing economic fundamentals in different ways than stocks and bonds, which are financial assets. Commodities tend to benefit from rising inflation as the rising price of commodities tends to rise in inflation. On the other hand, rising inflation pressurizes the equities market. Stocks and bonds perform better when the rate of inflation is stable or slowing.
At present, the commodities, stocks, and bonds are carrying positive correlation because of COVID-19 it will be a temporary one and the market will come back to the normalcy of carrying inverse correlation once the global economic activities are in full swing. Since most of the commodities are used as raw materials in many industries and economic activity has been severely affected because of COVID-19, the demand for the commodities is a lull at present.
Apart from traders, hedgers, and arbitrageurs, the Indian regulator has allowed participation of mutual funds, banks, and Alternative Investment Fund (AIF) category 3 in the Indian market. With this permission, mutual funds, banks, and AIFs have started operating in the Indian commodities market giving more positive vibes to the market to make it stronger. All in all, am of the view that one should look at commodities as an asset class.
The author is Head – Commodities and Currencies, ICICI Securities