Diana Clement: Commodities key to hedging inflation

Commodities as an investment class are often ignored by investors. That is in part because it has been historically difficult for the average investor to get involved in the international commodities market.

The markets for commodities such as wheat, coffee, sheep, precious and industrial metals, oil, cotton and even milk are all overseas.

What's more, buying most commodities in their own right is not feasible for private investors - unless you have room in the garage for a few thousand barrels of oil or somewhere to store tonnes of nickel and copper.

The key reason to invest in commodities is diversification. Commodity investments provide diversification in a number of ways, says Michael Coote, of fund manager Tower, which offers a commodities fund. Commodities can:

Provide a hedge against inflation and market shocks.

Add capital returns that are largely independent of sharemarket and bond market returns.

Have low or negative performance correlations with bonds and equities.

Help diversify commodities.

Commodities, says Coote, are generally split into three "big buckets" - energy, agriculture and metals. There is also diversification between the buckets and within the buckets.

The market supply and demand drivers for cattle production, for example, are very different from those for nickel or oil. And oil and petrol can behave differently - even though one is refined from the other, says Coote.

For example, petrol prices may be affected by the closure of a large refining plant, whereas that event may not affect oil prices.

Janine Starks, investment director at fund manager Liontamer, says that in the agricultural bucket wheat and soya beans are both agricultural products, but soya beans are also used as a key ingredient for the production of biodiesel.

Likewise, in the case of sugar, biofuels used almost 50 per cent of Brazil's total production.

"Because commodities are real physical assets, prices tend to react according to different criteria than more typical financial assets like shares and bonds," Starks says.

Another advantage of holding commodity investments is that they are a hedge against inflation - commodity prices tending to rise with inflation.

One thing that investors need to understand, says Starks, is that they are not going to earn an income from their commodities investments. "The return profile is quite different from equities, bonds and cash because all these produce some element of dividend or income stream, which commodities do not. Commodity returns come solely from capital appreciation, which helps explain their high volatility."

The choices for investors who want exposure to commodities include:

* Managed funds,

* Exchange-traded funds,

* Contracts for difference,

* Options and futures,

* Direct investment in mining and resources stocks such as NZ Oil & Gas, BHP Billiton and Rio Tinto,

* Physical purchase of precious metals.

The managed funds available to Kiwi investors include Liontamer's closed-end funds, with the next one launching in August, Tower's Global Commodity Fund, which allows investments at any time*, or overseas-based funds, of which there are many.

Exchange-traded commodity funds such as Barclays Global Investors' iShares GSCI Commodity-Indexed Trust are available on a number of markets around the world and can be bought through stockbrokers, as can direct investments in mining and resources stocks.

Both Coote and Starks say that investors should be aware that mining and resources stock investment do not provide true commodity exposure.

"Share prices will fluctuate according to management, market issues, cash flows, dividends,etc, and will not directly reflecta change in price of the underlying commodity," says Starks.

What is more, says Coote, these companies use the futures and options markets to hedge against their exposure to commodity prices.

Contracts for difference (CFDs) offered by companies such as CMC Markets and IG Markets are a way of making (or losing) money from commodity price movements without owning the commodities themselves. You simply arrange a contract with the company that offers CFDs, which you buy at one price and sell at another, making (or paying out) the difference.

The other option available to Kiwi investors who want exposure to commodities is to trade options and futures, which can be done through companies such as OM Financial. With futures you are entering into a contract to buy or sell a quantity of a commodity at a certain date in the future.

Unlike a future, which requires you to fulfil the contract on the settlement date, an option gives the owner the right, but not an obligation, to exercise the contract.

Coote says for the average investor CFDs, options and futures are too hands-on. "Individual commodities are extremely volatile," he says. "Profits can be there this morning and gone this afternoon. Most people don't have the time to be traders and they may not have the trader mentality."

Starks adds that the Liontamer commodities funds, which it offers each year, have capital protection and also hedge against movements in the NZ dollar, which exposes investors to exchange rate risks.

The other advantage of investing in a fund, says Starks, is that they offer exposure to a broad basket or index of commodities rather than investing in an individual commodity.

"At Liontamer we do not pick any single individual commodity. Rather, we prefer to have an exposure to a broad basket or index as part of a well diversified, risk-appropriate, long-term investment strategy."

Gold, silver and some other precious metals such as platinum are the only commodities that small investors may want to buy directly. They are available from precious metals brokers such as the NZ Mint.

In a recession, or any depressed market environment, says Starks, there is an opportunity to buy assets at discounts to their historical highs. "Commodities as an asset class, despite gaining some lost ground already this year, do appear to be relatively good value again, when taking a long-term view."

She says industrial metals may take some time to regain their 2007 highs. "Other commodities, like agriculture, livestock and energy, appear to remain subject to long-term fundamental factors: population growth; urbanisation; and shifting appetites from grain to meat in developing countries."

In the short term, says Starks, the outlook for commodities mostly depends on the immediate prospects for China, India and other emerging nations such as Brazil and Indonesia, and how they cope with the global recession.

"If growth in these areas slows dramatically then clearly commodity prices will suffer. If the United States emerges from recession faster or stronger than expected, this may counter some decrease in demand from emerging markets."

Unlike bond or share funds, which quite literally buy shares or bond issues, commodity funds usually don't involve the physical purchase of the commodity itself. In the case of the Tower Global Commodity Fund, investors' money is held in cash and fixed-interest and positions taken in the commodity futures market via swaps. When the markets rise, money flows into the fund and if they fall, money is paid out to the swap counterparties.

Funds may trade actively or passively follow indices such as the Dow Jones-UBS Commodity Index (DJ-UBSCI), which is designed to minimise concentration in any one commodity sector. That index currently includes 19 commodity futures in five groups: agriculture, energy, industrial metals, livestock and precious metals.

Unlike an index such as the FTSE 100, or NZX50, it is not straightforward what should be included in commodities indices. Weightings of underlying commodities in the DJ-UBSCI index are based on global production data and market liquidity.

A good commodity weighting for investors ranges from 2.5 per cent to 10 per cent, according to Tower. Coote says for an average balanced portfolio, an allocation of 2.5 per cent to 5 per cent would represent a modest amount of exposure.

For more aggressive investors or portfolios, 5 per cent to 10 per cent, or perhaps even higher, may be justifiable.

* The Tower Global Commodity Fund closes to new investment for 30 days each year and will not be accepting investments until July 17.