Commodities represent a diverse array of tangible assets. From an investment perspective, there are many vehicles available when looking for commodity exposure. It is important to understand what you get – and what you don’t – with each of them.
Residents of the United States, please read this important information before proceeding
Commodities are tangible assets, which can be classified into several sub-sectors, each with its own unique characteristics. (Figure 1) Investor returns from this asset class are dependent on price changes over time rather than cash flow from income such as dividends. While each type of commodity has its own idiosyncratic supply/demand drivers, broadly speaking, commodity prices tend to rise with economic growth: many commodities are the inputs into industrialisation and manufacturing and are consumed by growing middle-class populations.
As an asset class, commodities have posted negative returns every year since 2011, and in three of the last four years the sell-off in commodities was broad-based. (Figure 2) In 2011, the sell-off was driven by generally weaker demand and uncertainty in global economic growth, as the world real GDP YoY% growth rate fell from 4.00% in 2010 to 2.98% in 2011.1 In 2013 and 2014, commodity weakness was exacerbated by a strengthening US dollar, which increased by 4.2% and 10.5%, respectively, making commodities expensive and thus impacting demand.2 And the late-2014 sudden plunge in oil prices affected demand for other commodities, as investors’ appetite declined broadly for this sector.
With the combination of recent price declines and more optimism around future global economic growth, many investors are evaluating whether commodities exposure makes sense in their portfolios. As part of that consideration, it is prudent to understand how the various vehicles available for commodities investment stack up.
Commodities investment vehicles
There are numerous investment vehicles available to gain exposure to commodities. It’s notable that many of these vehicles have become available only in the last couple of years.3
Direct investment in physical commodities: Typically these types of investments are not undertaken due to the costs associated with storing and insuring the commodity. Usually if direct investment happens, it occurs with precious metals when companies hold gold bars, for example. The average investor is unlikely to directly own physical commodities.
Structured notes: These financial products are especially popular with investors who want exposure to commodity investments without bearing the full price risk inherent in direct ownership of the commodity itself. Usually maturities on these instruments are from 1 to 5 years. On the maturity date, the note repays the initial principal amount plus, or minus, a return that is derived from the price change of the underlying commodity. While this instrument may offer some simplified tax considerations, it also introduces counterparty risk and may be subject to certain minimum investment thresholds.
Swaps: These instruments exchange payments in which cash flows depend on changes in commodity prices and a principal dollar amount. By nature, these are over-the-counter contracts, and as a result, counterparty risk needs to be considered before investing.
Commodity trading advisors (CTA) and commodity pool operators (CPO): Using these investment vehicles, investors are effectively obtaining actively managed exposure to commodities. Usually CTAs and CPOs hedge their exposure to the commodity market and therefore they are not suitable for those who want to gain a broad exposure to the commodity asset class. Also, CTAs primarily use a trend-following strategy.
Derivatives: Investments can be made in individual commodities and commodity indexes through the use of futures and options contracts. Direct positions in derivatives on commodity indexes effectively provide broad exposure to this asset class. These were most popular before the introduction of ETFs and ETNs.
ETFs: Exchange traded funds (ETFs) are a cost-efficient way to buy exposure to commodities. These securities trade on exchanges like stocks, and they can represent claims on groups or individual commodities, though the ETF itself is investing in commodity futures. Investors may not exactly get what they expect by investing in these types of funds. One of the most popular oil ETFs is USO, with an average daily trading volume of nearly 16.5 million shares.4 However, returns from this ETF do not closely correspond to the returns from oil. (Figure 3) ETF managers often sell expiring futures contracts at a lower price than they pay for the new futures contracts they buy each month. This so-called “roll-over” is a common occurrence among oil ETFs which can leave investors frustrated.
Many funds have been launched in recent years to help reduce this problem, but more needs to be done in this area.
ETNs: Exchange traded notes (ETNs) are a type of debt security that can offer a cost efficient way to obtain exposure to commodities. Although ETNs, unlike ETFs, may offer better tax treatment and be less subject to roll-over than exchange traded funds. When purchasing ETNs, it’s important to consider the credit risk profile of the issuer, as an ETN’s value can drop if the issuer’s credit rating is downgraded.
Mutual Funds: Mutual funds utilise derivative instruments that are based on commodity indexes. These instruments tend to trade only at the end of the day at the net asset value and tend to have higher operating expenses and less tax transparency than ETFs.
Equities of commodity-based companies: A popular way to invest in commodities is to buy shares in the companies that produce the commodity. However, this approach is a stronger way to gain equity market exposure rather than commodity exposure: commodity-based equities have been found to have a greater correlation with the S&P 500 index (0.57) than with a commodity futures index (0.40).5 It is not uncommon for commodity producing companies to hedge their exposure to changes in commodity prices, and their share prices as a result do not directly correspond to movements in commodity price changes.
Attend to the details
For those considering commodities exposure, there are many decisions. Among them should be the careful review of the vehicle available for any such investment.
Mutual funds and exchange traded products (ETPs) are sold by prospectus. Investors should consider the investment objectives, risks, charges, and expenses of the fund or ETP carefully before investing or sending money. Call your Barclays Investment Representative or 1-888-227-2275 to obtain a prospectus that contains this and other information about the fund or ETP. Please read it carefully before investing or sending money.
Investing in either ETPs or mutual funds involves risk to capital. Investors might get back less than they invest.
The investments listed may not be suitable for all investors. Barclays recommends that investors independently evaluate particular investments, and encourages investors to seek the advice of an Investment Advisor. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives.
Commodities are assets that have tangible properties, such as oil, metals, and agricultural products. An investment in commodities may not be suitable for all investors. Commodities may be affected by overall market movements and other factors that affect the value of a particular industry or commodity, such as weather, disease, embargoes, or political and regulatory developments. Commodities are volatile investments and should only form a small part of a diversified portfolio. Diversification does not ensure against loss. Consult your investment representative to help you determine whether a commodity investment is right for you. Market distortion and disruptions have an impact on commodity performance and may impact the performance and values of products linked to commodities or related commodity indices. The levels, values or prices of commodities can fluctuate widely due to supply and demand disruptions in major producing or consuming regions.
Trading in options involves substantial risks and may not be suitable for all investors. As with all investments, clients should consult with their own legal, accounting and tax advisors to understand the consequences of any options transaction they are contemplating. Barclays does not provide tax advice. You must fully understand the worst case scenario before entering into any Options or OTC Derivative transaction. Prior to buying or selling any option, clients should review the documents titled Characteristics & Risks of Standardized Options (http://www.optionsclearing.com/about/publications/character-risks.jsp) and November 2012 Supplement to Characteristics & Risks of Standardized Options (http://www.optionsclearing.com/components/docs/about/publications/november_2012_supplement.pdf [PDF, 18KB]).
Structured investments are financial products whose return is linked to the performance of an underlying asset. These investments are debt instruments combined with derivatives that are used to provide exposure to a variety of asset classes. Any payment on the Notes below, including any principal protection feature, is subject to the creditworthiness of the issuer and is not guaranteed by any third party.
1 Source: Bloomberg, as of December 31, 2014.
2 Source: Bloomberg, as of December 31, 2014, Trade-weighted US Dollar Index.
3 Source: Commodities as an Investment, Gerald R. Jensen, Jeffrey M. Mercer (2010).
4 Source: Nasdaq, as of January 15, 2015.
5 Gorton and Rouwenhorst (2006), sample period from 1959 to 2004.