Commodities' role in portfolios

THE LONG AND SHORT OF INVESTING: Arabica beans on a Brazilian farm. A severe drought in Brazil has damaged crops and sent prices soaring this year. Those investing in commodities can buy with a view that prices will rise in the future, what is known as going "long". Investors can also "short" sell if they feel a commodity's price will slide.


    Mar 24, 2014

    Commodities' role in portfolios

    WITH Brazil's north-east facing its worst drought in 50 years, coffee prices soared almost 90 per cent in the first three months of the year, as rough weather damaged the crops of the world's biggest java producer.

    Over in Europe, fears of a cut in the supply of natural gas, brought on by the political turmoil in Ukraine, sent prices surging last month.

    While these two recent examples highlight the volatility of commodities, they also show how their prices are affected by demand-supply fundamentals, including geopolitics, weather and environmental risks.

    Commodities, with their different risk factors compared to stocks and bonds, can thus be a good way to diversify an investor's portfolio, said Mr Simon Teo, strategist and private-client service manager at Phillip Futures.

    "Over the long term, commodities, as a whole, have low correlation with traditional asset classes like stocks... it can help to smoothen the volatility in one's portfolio," added Mr Teo.

    Besides diversification, commodities also offer a hedge against inflation, driven by the rising prices of raw materials, such as crude oil and metals.

    Commodities are also a window for tapping into the growth potential in the emerging markets of BRIC (Brazil, Russia, India and China), noted Mr Teo. "As these countries develop and urbanise, there's a high demand for raw materials to build infrastructure. With a growing population, agricultural commodities will also be in demand," he explained.

    However, he noted that a recent slowdown in China's economy has also dampened the demand for copper, which is needed to support the country's manufacturing industry.


    Commodities are typically divided into five categories: agricultural, livestock, energy, precious metals and base metals.

    One way to start investing in them is through commodity futures, which requires comparatively less capital compared to investing in, say, exchange-traded funds or stocks.

    The trading of futures involves buyers and sellers agreeing by contract to move a quantity of a particular commodity at a pre-determined price, with delivery and payment made at a later date.

    Besides buying with the view that prices will rise in the future, what is known as going "long", an investor can "short" sell if he feels a commodity's price will slide.

    This means that he will agree to sell at a certain price first, and hope to buy the commodity later at a cheaper price, hence making a profit.

    The prime advantage of commodity futures is leverage, which means that for a relatively small sum, an investor can own a contract of a much larger size.

    In most cases, an investor will need a margin of between $1,000 and $10,000, depending on the commodity, but the actual contract value may be 10 to 20 times larger.

    However, this margin is a "double-edged sword", said Mr Teo, as the risks are also higher.

    While the margins are small, investors are thus advised to have more in their trading accounts, by between half and a third of the full contract value.


    Depending on one's risk appetite, commodity futures can be used for speculation or investment. Taking advantage of sudden price spikes or dips, speculators can enter and exit the market in as short as a day.

    For investors, they can hold on to their contracts for a longer time, and ride out the price volatility. Commodity future contracts have an expiry date of between a month and a quarter, which may be rolled over.

    Unlike assets such as stocks, which require a close watch and understanding of the financial world, the indications about which commodities to get into and when to buy or sell can be discerned by following news developments.

    "If you read the news and see what's happening around the world, like in Russia and Ukraine, you can easily analyse the price movements of commodities," Mr Teo said.