New Century International

Investment in commodities is receiving increased interest during hard economic times. Commodities include resources, agricultural products, and energy products. There are commodities that can be stored for a long period of time and those that cannot. Those that cannot be stored for a long time are referred to as “soft” commodities. Commodities are nothing new. The demand for standardized contracts for trading agriculture is a more recent development and began in the 1800’s. This eventually led to commodity futures exchanges being developed. The custom of transporting bushels of wheat or corn to the local market slowly disappeared and today, futures and options contracts can be traded on exchanges around the globe. A variety of agricultural products, energy products, metals, and soft commodities are available today to trade.

With the development of commodity futures indexes and investment vehicles that track commodity indexes, commodities have grwon as an asset class. An increasing number of investors look into adding commodities to their investment portfolio.

With financial instability, investors are looking to putting their “eggs” into many different “baskets”. It doesn’t matter if this is referred to as diversifying or creating addition streams of income, the result is the same, it will contribute to financial stability. In a varied portfolio, when one or more investments aren’t producing or losing money, there will be others to keep the investments stable.

As investors are taking a loss with stocks and bonds, commodities are a becoming appealing because they have out performed traditional assets. As an asset, commodities are measured by the returns on a commodity index, which have been good.

Commodity prices have been affected by the following factors:

• Increased demand from China, India and other emerging countries that need commodities to support manufacturing and infrastructure development.
• The commodity supply chain lacks of investors
• “Insurance premium” and/or a “convenience yield” added to the returns of many commodity futures.
• Economic factors that support continued gains in commodity index returns

The most obvious attraction to commodities by investors is the potential for returns, but it is not the only factor. There are other benefits to commodities, which includes enhanced portfolio diversification and a hedge against inflation and event risk.

Commodities differ from stocks and bonds in the following ways:

• Commodities are “real assets” and stocks and bonds are “financial assets”. During changes in economic fundamentals cause each to react differently.

EXAMPLE-Of the asset classes, commodities are one of the few asset classes that tend to benefit from rising inflation. When the demand for goods and services rises, so do the price of those goods and services usually rises with the demand. This will cause the rise in the price of the commodities used to produce those goods and services that are in demand. Investments in commodities may provide an investment portfolio with a hedge against inflation.

When inflation rate is stable or slowing, stocks and bonds tend to perform better. Faster inflation lowers the value of future cash flows paid by stocks and bonds because those future dollars won’t be able to purchase as much as it does today. This happened during the 1980s and 1990s, when inflation fell and stocks and bonds experienced bull markets.

• Commodities have been positively connected with inflation, while stocks and bonds are negatively connected.

EXAMPLE-The returns from a broad and diversified commodity index such as the Dow Jones AIG Commodity Index have historically been largely independent of stock and bond returns but positively interrelated with inflation. The quarterly returns on the Dow Jones-AIG Commodity Index have been negatively correlated with both the S&P 500 and the Lehman Brothers Aggregate Bond Index (LBAG). The quarterly returns have been positively correlated with both the CPI and the quarterly change in inflation. This has been occurring since December 1990.

Diversification is one of the significant benefits of investing in commodities. The Dow Jones-AIG Commodity Index’s lack of correlation with stocks creates the diversification needed to reduce portfolio risks. The goal is to have assets that do not move in sync with each because it creates stability of the overall portfolio. Increased stability reduces portfolio risk, and that will significantly increase the probability of consistent returns over time. Not only does diversification reduce potential risk, it improves returns at the same time. Of course there is no way to guarantee an investment will result in profits and there is no way for diversification to guarantee no loss, but it does reduce the risks considerably.

In addition to the benefits of diversification, commodities may also offer investors a hedge against “event risk”. The following events may cause assets to fall:

• Financial crisis
• War
• Geopolitical

An example of an event risk (geopolitical) is when Iraq invaded Kuwait in 1990. At that time commodities performed well while equities faltered. During the stock market crash of 1987 (financial crisis) commodities provided diversification.

Like with any asset class, commodities do have some risks. Commodity returns tend to be about as volatile as equity returns, and have the potential of periods of underperformance. Even with the similarities in volatility, equities and commodities have rarely fallen in the same year and it is expected to be the same in the future. Over a 35-year period from 1970 through 2005, only twice did both indexes produce negative returns in the same year.

Diversity, reduced risks, and returns are all good reasons to be investing in commodities.