The world of investments has a vast number of financial instruments such as shares, stocks, bonds and many more. Commodities, too, are one such investment option available for investment. Even though the commodity market has grown substantially in the last few years, the participation of retail investors in commodities is still limited. However, the commodity market has huge potential and making the right investments in commodities can help improve the performance of your portfolio.
What are commodities?
Commodities are tangible goods that are either naturally occurring or can be agriculturally grown. Commodities are consumed directly or used as raw materials for manufacturing finished goods meant for public consumption. All commodities can be classified under either of the two categories-
- Soft commodities- Those, that are grown and cannot be stored for an extended period. Examples of soft commodities include agricultural products such as grains, tea, coffee, and livestock.
- Hard commodities- Those, that are obtained through mining and extraction. Example of hard commodities includes oil, metals and natural gas.
Why should you invest in the commodities market?
Commodities play an important role in the development process and hence are building blocks of every economy. Commodity investments can help you diversify your portfolio into a different asset class apart from shares and bonds and enhance the overall returns of your investments.
For many of you, the general perception is that the commodity market is complex and hence not something that everyone can dabble into. However, commodity investments can fetch you handsome returns.
Here are the top three reasons to invest in commodity markets for all types of investors-
1. To diversify your portfolio
One of the key factors that determine the success of your financial planning is diversification. Diversification with regards to investment portfolio means investing in various assets that are not correlated to each other of your portfolio in different asset classes. Most of you would be diversifying your portfolio in five major asset classes which include cash, shares, fixed income securities, real estate, and gold. In times of increased volatility in the markets, you are either holding on to cash or investing in gold. Gold is considered the safest haven for investment in turbulent times and Indians tend to invest in gold because it is considered as a symbol of wealth and has ornamental value. However, in reality, the gold in your portfolio is your investment in commodity and just like all the other commodities the returns from it are independent of the returns generated by stocks and bonds.
Just like gold, there are other commodity investments whose returns are not correlated to equities and bond markets. The price of any commodity investment is a function of demand and supply and by doing proper research and analysis you can make profits from commodity market investments.
2. To provide a hedge against inflation
Inflation is the general rise in the price of goods and services over time. For any investment to be fruitful, it is important that the returns generated beat the rate of inflation. Higher inflation effectively erodes the real returns generated by your investments in stocks and fixed income securities. However, in the case of commodities, higher inflation relates to the higher price of commodities. So, unlike other investments, your commodity investments will result in a strong performance when inflation is high. Given the current situation when inflation is constantly on the rise, investing in commodities will provide a hedge against inflation.
3. To improve potential returns
The prices of individual commodities can fluctuate significantly due to several factors such as demand and supply, the impact of natural calamities, exchange rates and the economic health of the nation. The rise in infrastructure projects in a developing country like ours and also globally has had a positive impact on commodity prices.
As the commodity market is still an untapped arena, many of them are trading at a lower price than their actual potential. Proper research and effective implementation of investment strategy in commodities can help investors improve the overall returns on their portfolio.
What are the various options to invest in commodities?
The commodities market is a very deep market and investors have many investment vehicles to access it. Let us look at the various options available for investors to buy and sell commodities
1) Investing in the physical form
Commodities such as gold, silver, etc., are bought by investors in physical form. However, not all commodities can be bought in physical form as it has its drawbacks of storage and spoilage. Even in the case of precious metals security and insurance increase the cost of your investment. Moreover, most of the time you want to invest in a commodity, not for end-use but to make profits if you anticipate that the price will increase. So, buying a commodity in physical form, except for precious metals, is generally not recommended for retail investors.
2) Investment through commodity futures
One of the most common ways to trade in commodities is through a commodities futures contract. It is a standardised agreement to buy or sell fixed quantities of the underlying commodity at a predetermined price on a specific date as mentioned in the contract. Also, commodity trades happen electronically through commodity exchanges where investing real-time commodity is possible. Multi Commodity Exchange of India (MCX), National Commodity and Derivatives Exchange (NCDEX) are two of the many commodity exchanges present in the country which help investors trade in commodities. All the commodity exchanges come under the regulation of the Forward Markets Commission (FMC).
3) Commodity ETFs
Commodity ETFs are another popular investment option available for retail investors to diversify their holdings in commodities. Commodity ETFs invest in a single commodity and physically hold and store it, invest in a commodity futures contract or invest in a commodity index that tracks the performance of multiple commodities. Investors can invest in commodity ETFs electronically in their Demat account.
4) Commodity Stocks
Investors who are not comfortable with investing in commodity futures or ETFs can diversify their portfolio in commodities is by investing in commodity stocks. Commodity stocks are stocks of those companies which are directly or indirectly related in the manufacturing process of the commodity and hence have a positive correlation with the commodity. For example, if you feel that the steel prices are going to increase, then you can invest in the stocks of various steel companies listed on the exchange.
5) Mutual funds
One of the biggest reasons for an investor to shy away from commodity investment is that commodity investments require a lot of time, knowledge and expertise to make the right investment choices. However, now SEBI has permitted mutual funds to invest in the commodities market through the exchange-traded commodities derivatives (ETCD) route. Thus, retail investors can now participate in commodity markets in a structured manner through professionally managed mutual funds.
Commodities are a broad and diversified asset class that offers a great investment opportunity to investors. Given the high inflationary pressure and volatility in the markets, dedicating a small portion of your portfolio to commodities will help enhance the overall performance of your investments.
Investing in commodities may look intimidating and you may feel a little hesitant to explore your options, but correct guidance from an experienced financial advisor can help you understand the nuances of commodity markets and make the right investment decisions as per your investment needs. Financial advisors at IndiaNivesh possess the requisite expertise and experience to help and guide you with investments in commodities markets.
Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.