Commodities have developed into a separate asset class for investors looking to diversify from traditional asset classes such as equities and bonds. In this article we will focus on commodities as an investment option. We will look at the advantages and disadvantages of investing in commodities and also look at the different options to invest in commodities.
Ways to Gain Exposure to the Commodity Markets
Direct Investments
Direct Investments in commodities refers to buying the physical asset. However, this is very impractical considering the storage, transportation and insurance costs involved in buying physical commodities. Direct investments in commodities is practiced very rarely exception being some developing countries like India where people buy gold and silver.
Commodities Derivatives
One of the easiest ways that investors use to gain exposure to commodities is through commodities derivatives. Commodities derivatives include over the counter swaps and commodity futures, which are mainly traded through organized exchanges. Commodities futures are particularly used to gain exposure to commodities asset class. Commodities futures contract is a bilateral agreement where one party obligates to buy and another party to sell a commodity through an organized exchange at a set price and on a specified date. However, delivery of commodity is not required to close a futures contract as an investor can close the contract by taking the opposite position to the one he had previously taken.
Index Products
Another option to gain exposure to commodities is through Index products targeting commodities indices such as Exchange Traded Funds (ETFs). By investing in Index based products, an investor can gain exposure to a number of commodities and does not have to actively manage each contract individually unlike a Futures Contract.
Pooled Commodity Funds
A commodity fund is a collection of investors, who pool their funds to invest in the commodities futures market. They are a subset of the hedge fund market. Commodity funds are managed by a general partner who must be registered with the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA).
Equities related to Commodities.
One way of gaining exposure to commodities is through investing in equities of listed companies that derive majority of their revenues from buying and selling physical commodities. The profits of such firms depend on the prices of commodities.
Commodity-Linked Note
In a Commodity-Linked Note an investor can combine a standard interest paying debt instrument with either a commodities futures contract or an option on commodity prices. The bond investor accepts lower coupon payments in exchange for receiving the upside potential from commodities. Commodities-Linked Notes have credit risk.
Advantages of investing in Commodities
Ways to Gain Exposure to the Commodity Markets
Direct Investments
Direct Investments in commodities refers to buying the physical asset. However, this is very impractical considering the storage, transportation and insurance costs involved in buying physical commodities. Direct investments in commodities is practiced very rarely exception being some developing countries like India where people buy gold and silver.
Commodities Derivatives
One of the easiest ways that investors use to gain exposure to commodities is through commodities derivatives. Commodities derivatives include over the counter swaps and commodity futures, which are mainly traded through organized exchanges. Commodities futures are particularly used to gain exposure to commodities asset class. Commodities futures contract is a bilateral agreement where one party obligates to buy and another party to sell a commodity through an organized exchange at a set price and on a specified date. However, delivery of commodity is not required to close a futures contract as an investor can close the contract by taking the opposite position to the one he had previously taken.
Index Products
Another option to gain exposure to commodities is through Index products targeting commodities indices such as Exchange Traded Funds (ETFs). By investing in Index based products, an investor can gain exposure to a number of commodities and does not have to actively manage each contract individually unlike a Futures Contract.
Pooled Commodity Funds
A commodity fund is a collection of investors, who pool their funds to invest in the commodities futures market. They are a subset of the hedge fund market. Commodity funds are managed by a general partner who must be registered with the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA).
Equities related to Commodities.
One way of gaining exposure to commodities is through investing in equities of listed companies that derive majority of their revenues from buying and selling physical commodities. The profits of such firms depend on the prices of commodities.
Commodity-Linked Note
In a Commodity-Linked Note an investor can combine a standard interest paying debt instrument with either a commodities futures contract or an option on commodity prices. The bond investor accepts lower coupon payments in exchange for receiving the upside potential from commodities. Commodities-Linked Notes have credit risk.
Advantages of investing in Commodities
- Investing in commodities provides a natural hedge against inflation.
- Commodities are negatively correlated with equities and bonds. Therefore an investor can diversify by including commodities in his portfolio.
- Commodities also provide protection against geopolitical risks.
- Commodities do not pay cash flows.
- Commodities cannot be valued as they do not pay cash flows.
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