The S&P GSCI is a widely tracked commodity index that comprises commodities ranging from energy and metals to agriculture and livestock. At the time of this writing, the GSCI is down by more than 43% over the last year. Light crude is down by more than 52%, heating oil 46%, unleaded gas by close to 50%, and both copper and sugar by more than 25%.
Sound like a commodity bear market you should stay away from?
Maybe this will change your mind. During the same period (i.e. a year back), if you had invested in DEE, a 2x short commodity ETN, you would be up by 111%. If you invested in CMD, a 2x short commodity ETF, you would be up by 65%. If you invested in BOM, a 2x short ETN that tracks metals, you would be up by 59%.
The examples above are of leveraged ETFs/ETNs that made a lot of money because they moved in the opposite direction of the market by two times. All good investors will tell you that no matter what the situation is there is always a great investment idea waiting. If you think commodities have had enough of a rough year and are now poised to recover, why not pick some leveraged bull ETFs? If they recover by even 2% (low demand and oversupply can’t last forever) you stand to gain 4-6%.
Now, it is always a bad idea to try and time the market, but there seems to be a growing consensus that commodity prices are turning around. Before we move into the whats and hows of commodity investing, it’s prudent to consider the flip side, too. So here are the top reasons why commodity prices may not go up in the near term.
- Earlier this year in July, the IMF trimmed down its global economic growth forecast for 2015 (2016 forecast seems to be better).
- China has stopped trying to live up to China-nomics and is looking to settle for a new sub-10% normal. That means they may not have the same hunger for commodities.
- Oil prices might not come back to their previous highs any time soon. In fact, some analysts think it may never get back to $100/barrel.
Despite the above concerns, the Federal Reserve and Bank of England are likely to raise interest rates in the next year. While it will put commodities (or growth projections in general) under a bit of pressure, it is a clear signal that they don’t see any structural problems with their economies now. It may not be the worst idea to start buying in slowly instead of trying to make one big move.
Forget Timing: Commodities Should Be a Part of Your Portfolio
Even if you are not sure about the timing, commodities are a very good venue to diversify your portfolio. Here is why:
- Commodities have low to negative correlation to stocks and bonds. Adding a commodity component to your portfolio might actually reduce overall risk. Isn’t that handy to have?
- The returns are often comparable to equities and much better than fixed-income instruments.
- Commodities have a positive correlation to inflation. That means they are a good protection against the effects of inflation (not many asset classes have that).
- Commodities can be fairly independent of each other. Take cotton and copper for instance, there is very little in common between the two.
How to Invest in Commodities
There are several ways to invest in commodities. The most authentic form of commodity investing is through futures, but that’s not for everyone. The learning cycle for mastering the nuances of futures and commodities at the same time is pretty high. The second way is to get expert help (either a managed account or a fee-based advisor), and the third way is the obvious mutual fund option. Last but not least (unless you are talking about cost), are the exchange-traded funds (ETFs).
The rising popularity of ETFs is a testament to their usefulness (4x growth in assets and 2x growth in number since 2008). There are more than 1,400 ETFs in the U.S. alone, of which more than 150 are dedicated to commodities. That gives investors a large variety of choice in terms of focus area. Some broad, index-based ETFs have fallen sharply in the last year. DJCI (down 26% in the past one year) tracks energy, metals and agriculture, with caps on segments to avoid overexposure. USCI (down 25% in the past one year) tracks energy, metals, grains, softs and livestock. GSG (down 44% in the past one year) tracks energy, metals, agricultural, and livestock. If you think any sector or index might recover, you could invest in some 2x long or 3x long ETFs.
The Bottom Line
If you have ever thought of getting started with commodities, this may be a good time take the plunge. Commodities have low correlation to stocks, bonds, and even between themselves. That’s really good for reducing portfolio risk. Since trading futures is not for everyone, commodity ETFs give investors a convenient, low-cost vehicle to gain that exposure. If your risk appetite is higher, you could invest in long or short leveraged ETFs to give you two to three times market returns. The good part about leveraged long ETFs is that they will have two to three times the correlation to inflation, and since you don’t need a margin account to buy them, you can buy and wait for some time (without worrying about the interest adding up).
Note: Investors need to be careful not to confuse buying stock in commodity producers as a “commodity investment”. That will just add more equity to a portfolio. Investors want to invest in commodities themselves (e.g. oil, cotton, metals) for it to count as a commodity investment.
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