Renowned commodity investor Jim Rogers says he is long on commodities and currencies because if the world economy improves, shortage of commodities will ensure he makes a profit, and if it does not, then too he will make money. "Throughout history, when things have gone wrong, they print money...when they print money, you should own silver, you should own rice, you should own real assets," he says.
Commodities, it seems, are the toast of investors. For retail investors, though, direct investing requires either taking delivery, which is difficult, or trading in futures, which most find tough to understand.
Inability to directly deal in commodities takes small investors to mutual funds that invest in commodities either directly or through stocks of commodity companies. In India, mutual funds can directly invest in only one commodity-gold. So, most commodity funds, except gold exchange-traded funds, either invest in shares of commodity companies or buy units of funds that invest in such companies.
Pros and Cons
Since commodity funds invest in stocks instead of commodities, their returns may not be in line with the underlying commodities. Commodity prices depend on demand and supply, while share prices of companies depend not only on availability of commodities they manufacture but also on fundamentals, the overall equity market sentiment and macro-economic factors.
"The performance of commodity companies is prone to factors and sentiments driving equity markets in general which may not always play out favourably from investors' perspective. For instance, in 2011, major commodities such as gold, thermal coal, copper, aluminum and iron ore are up 20-30% year-on-year but stocks of companies dealing in these commodities have been beaten down due to the global macroeconomic uncertainty," he adds.
Take the relation between the share price of Reliance Industries, a crude oil refiner, and Brent crude oil. Over the past one year (6 December 2010 to 5 December 2011), while crude oil price rose 37%, the RIL stock fell 20%.
However, there are positives as well. A rise in commodity prices and a company's superior fundamentals can deliver better returns than the underlying commodity. For instance, gold prices have risen 31% annually on a compounded basis over the past three years, while AIG World Gold and DSP BlackRock World Gold, which invest in gold mining companies, have given returns of 41% and 38%, respectively.
Another point to remember is that most commodity funds invest in global companies either directly or through funds with exposure to these companies.
Global funds expose investors to currency and country-specific risks. Any fluctuation in currency may severely impact gains. Suppose you buy units of a commodity fund that invests in a US commodity fund and at the time of redemption the rupee appreciates against the US dollar. In such a situation, your profit in rupee terms will be hit as you will get fewer rupees per dollar. However, if the rupee depreciates against the US dollar, you may gain.
"Given that natural resources are located across continents, transactions in commodities (and therefore commodity stocks) go through multiple currencies, exposing investors to currency risks," says Gopal Agarwal, CIO, Mirae Assets.
Country-specific risks include political and economic instability in the country your investments are exposed to.
Some commodities are cyclical, that is, their demand is high during a specific period. This is reflected in the stock price of companies that deal in such commodities. This makes returns from some commodity stocks and funds volatile.
Pankaj Pandey, head of retail equity research at ICICI Direct, says, "Commodities are cyclical in nature and, therefore, commodity funds are more volatile compared to diversified equity funds. It is also difficult to time the commodity cycle."
The commodity space looks attractive in 2012 but that does not mean investors should increase exposure to commodity funds disproportionately. These are basically equity schemes with a commodity theme and should not constitute more than 10-15% of your overall portfolio.
Amarsingh Deo, head, commodities and currencies research, Aditya Birla Money, says investors must be aware of the supply and demand fundamentals of commodities in which their fund invests. "They should do a thorough analysis of companies' financial prospects," he says.