Investment Advice

What are Commodities?

With rising energy prices and geo-political pressures, commodities such as oil and gas continue to be headline news. As a UK investor you’ve probably read a lot about increased prices and have already felt the knock-on effect on your domestic fuel bills. However, energy is just one commodity sub-sector. Commodities encompass many materials, such as energy, livestock and agricultural products, as well as precious and industrial metals. Unlike equities or bonds, commodities tend to have a physical use.

A key benefit of commodities for investors is their low performance correlation with other asset classes. Indeed, many commodity sub-sectors do not even have a high correlation with each other. So, a diversified selection of commodities can provide a useful way of managing risk within your portfolio. As commodities are physical, tangible assets, many investors perceive them to be a safer investment option than the intangible options. However, they would not be suitable for income investors as there is no ‘dividend’ as there is with some equities.

In recent years, the strength of some commodity prices have been boosted by demand from global powerhouses such as India and China and this demand looks set to continue. However, those same commodities have also been blamed for causing rising inflation (when demand exceeds supply this can create inflationary pressures as prices are driven up by those most desperate to buy). Since there is strong demand but a finite supply of most commodities, this may continue to be a problem until alternatives are found.

As a UK investor, you can invest directly in commodities, although this isn’t really practical for most – after all, where would you store a million tonnes of copper? Even in professional circles, most commodities trading is typically done using futures and options, as these allow investors to speculate on prices of future deliveries before they arrive.

For the average investor, however, there are pooled products which invest in a range of different commodities, or gain exposure to the sector through the shares of companies operating in it. Finally, you could choose funds that target commodities sector stocks. But remember, even if you just own a FTSE 100 tracker fund, you will already have some exposure as oil and mining stocks are well represented amongst the largest in the UK. You don’t want to end up over-exposed without realising it.

© 2009 Paul Parr – Financial Planner.