Commodities hold their allure

Gold, coffee, sugar, wheat and other products offer a diverse and lucrative investment opportunity. But there is plenty to know before you dive in.

RADSTOCK, UNITED KINGDOM - AUGUST 18:  (EDITORS NOTE: A GREY GRADUATED FILTER WAS USED IN THE CREATION OF THIS IMAGE) Wheat grows in a field near Radstock on August 18 2008 in Somerset, England. Many farmers in the UK are reporting difficulties in harvesting their crops, due to the continued wet weather and with more rain forecast for the coming weeks, the harvest may be delayed still further.  (Photo by Matt Cardy/Getty Images)
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You would have to be living with your head in the sand not to realise that the prices of many commodities are rising again. Commodities as an asset class outperformed equities by 7 per cent in the first half of this year, while some individual commodities clocked up price rises of as much as 58 per cent. The outperformance is not just over the short term. In the past 10 years, commodities as an asset class as measured by an industry benchmark (see chart) have returned 270 per cent, as compared to a 7 per cent fall in the FTSE 100 and a 27 per cent drop in the Dow Jones Euro Stoxx 50. Commodities overall are heading for their biggest rally since 1974, according to London-based fund group ETF Securities.

But given that last year witnessed the sharpest fall in commodities prices for a decade, can investors trust that the current resurgence will be anything more than a medium-term blip? Daniel Wills, a senior analyst at ETF Securities, said that it was important for retail investors to look behind the headline rises and consider what factors might be driving demand for particular commodities. "It was inevitable that the price of gold would rise in the aftermath of the credit crisis, as gold is always seen as a safe haven," he said. "However, the renewed interest in industrial metals since March has not been across the board; investors are discriminating. Copper went up 58 per cent [in the first half of the year] because it has the lowest inventory overhang, whereas aluminium rose only 1 per cent because it has the highest inventory on record."

Mr Wills is not alone in stressing that it's important to look at the fundamentals underlying the recent surge in demand for commodities before taking a view on whether these latest rises will turn out to be sustainable. Waseem Didan, an investment adviser at, said: "The industrial development of China in recent years was responsible for much of the world's increased consumption of industrial-use [base] metals."

He says a surge in base metal prices reversed the fortunes of mining projects that were previously seen as unviable, as their owners decided they could now be profitable. But when demand for base metals from nations such as China dropped, the higher marginal production costs of these newly opened mining projects, coupled with falling base metal prices, led to a significant decline in revenue for producers, Mr Didan said.

Another factor influencing current demand is Mother Nature. Weather forecasters are predicting a hot, dry summer this year. If this proves correct for the rest of the season it is likely that prices for "soft" commodities that require a lot of water to grow, such as wheat, corn and soybeans, will rise. Mr Wills believes that the credit crunch is also playing its part in driving up prices for soft commodities, such as coffee. The Dow Jones-UBS Coffee Sub-Index has risen 22.5 per cent so far this year.

"A lot of production of soft commodities is concentrated in emerging markets," he said. "Bottlenecks in production are coming through now, because some producers in emerging markets are finding it very hard to maintain production because of problems getting credit." Add to this the growing world population, and in particular the rise in middle-class numbers in countries such as China and India, and the idea of investing in food commodities for the long term seems a wise one.

"Despite the global financial crisis and dampened economic demand, populations continue to grow, adding to the depletion of arable land supply through a combination of environmental degradation and the 'consumption' of land for residential housing," said Mr Didan. As families and populations become more affluent, they increase their consumption of meat. According to the United Nations, it requires 6.5 kilograms of grain crops to produce just 1kg of beef. An increased consumer demand for meat will thus push up demand for crops, including maize and wheat. As there is only a limited amount of space available on the planet to grow these crops, economic theory maintains that the prices of such crops should therefore go up.

So what should an investor seeking to add commodities to his or her portfolio do? It used to be the case that the man in the street could gain exposure to commodities only through buying the stocks of mining and agricultural producers, or funds that focused on them, as it was not really practical or efficient for small investors to buy an individual barrel of oil or bale of wheat. That is no longer the case. Today, there are myriad options for those looking to capitalise from the sector, including exchange traded funds (ETFs), which allow investors to gain exposure to individual commodities or baskets of commodities.

Products focused on precious metals have traditionally been the most popular for investors choosing this option. However, recent innovations in both conventional and Sharia-compliant products have made possible direct physical exposure to a much wider range of hard and soft commodities. Alternatively, with mining and resource shares, investors can gain exposure not only to the underlying commodity, but also to the potential of the companies that mine or grow the commodities as well.

"Take a gold mining company as an example," said Mr Didan. "For every percentage movement in the gold price there is an exponential movement in the share price of the mining company because metal price movements directly affect profit margins and the value of the deposits. As rising metal prices do not lead to risings costs of production, already-profitable companies accrue incremental revenues. For mining companies that are not profitable, a rise in the metal prices can suddenly equate to profitability and a higher share price.

"The upside to the speculative mining and resource stocks is that if the company does hit pay dirt it can be extremely profitable, yielding an investor several multiples on their initial investment." Individuals who do not feel confident about the prospect of choosing the mining and resources companies most likely to prosper can instead opt to invest in a resources-focused mutual fund. Keren Bobker, a senior consultant at the Dubai-based financial adviser Holborn Assets Insurance Brokers, said that there are around 15 to 20 such funds available via offshore insurance company products alone.

However, she added that investors with a bit more cash, typically £100,000 (Dh600,000), who opt to invest through a personalised portfolio bond (PPB) will be able to access pretty much any unit trust, investment trust or SICAV (European-style open-ended collective investment scheme) on the UK and European markets. "One of the better-known funds in this sector is the Blackrock - formerly Merrill Lynch - Gold and General Fund, which was launched in 1988. It has a narrow investment strategy, with some 75 per cent of the fund invested in gold mining companies," Mrs Bobker said.

"The latest figures available from Blackrock's website are dated March 31 this year, and these show that while the fund significantly outperformed the sector average over five years, there was a substantial underperformance over the 12 months to that date." Mr Bobker said that while the fund "has a long history, if a client was adamant they wanted to invest in a gold fund, I would be inclined to consider the Investec Global Gold Fund, which is available through all of Royal Skandia plans and PPBs from most providers. While the Investec product was launched only April 2006, it has been rated 'A' by Standard & Poor's, and over one- and three-year periods has produced top-quartile returns".

Set against this, investors should remember that while individual mining companies can succeed or go bust, a commodity cannot. Mrs Bobker also warns that many of the funds in this sector are relatively new - less than five years old - and their performances can be greatly affected by currency movements. A quick glance at figures illustrates their volatility. At the end of May this year, average returns for the sector over six months, one year, three years and five years were, respectively, 37.25 per cent, -36.96 per cent, 6.17 per cent and 78.49 per cent, quite a roller-coaster ride.

For investors who do not want to run the risk of a company going bust, ETFs specifically focused on commodities might be worth a look. These allow you to take advantage of the general direction in the price of commodities without risking exposure to any particular producer or distributor. If you are considering using an ETF to gain exposure to commodities, make sure to read the small print of any ETF in which you want to invest. Specifically, make sure that an adequate percentage of the fund's portfolio is backed by holdings in the actual physical commodity.

One way to ensure that you are buying an ETF that is 100 per cent held in a physical asset is to opt for an Islamic ETF. As well as the requirement to be totally backed by the asset, Sharia rregulations demand that these ETFs cannot employ leverage or engage in short selling. ETF Securities launched five such Sharia-compliant ETFs in July of last year: ETFS Physical Platinum, ETFS Physical Palladium, ETFS Physical Silver, ETFS Physical Gold and ETFS Physical PM Basket. Since their launch, trading volumes across the five funds have averaged US$2.2 billion (Dh8.08bn) a month, no small amount.

One thing is clear - there is a plethora of options for investors who are confident that commodities will continue to rise and are looking to capture a piece of that expected gain.