How To Pick A Product: Commodities

The so-called commodities super cycle has run its course, with prices back to where they were in the late 90s.

Soaring demand for coal, oil and metals from Chinese manufacturers powered a bull market in commodities that peaked in 2008. Since then, Bloomberg's Commodity Index, which tracks the performance of 22 natural resources, has plunged by two-thirds to the lowest level since 1999.

This asset class comprises a diverse range of investments covering everything from gold, oil and copper to soybeans and wheat.

"There is little commonality across these investments; the expertise needed to understand gold are not similar to the knowledge required to understand the pricing of agricultural goods," said Adrian Lowcock, head of investing at Axa Wealth.

Investing in commodities gets even more complex when you consider the number of ways there are to achieve this. Let's look at the options.

ETFs

Traditional trackers in this asset class are hard, if not impossible, to find: "There aren't any tracker funds in commodities that I've come across really; there's too much choice and variety going on," said Lowcock. However, you can invest passively via exchange-traded funds (ETFs).

These enable investors to trade in and out of positions intraday and gain simple exposure to the spot price movements of a commodity.

ETF Securities listed the world's first gold exchange-traded commodity (ETC) in 2003, providing an easy, transparent and cost-effective method for investors to access gold.

"ETCs are transparent, open-ended securities that trade on regulated stock exchanges," said Howie Li, an executive director of ETF Securities. "Overall, they enable investors to gain exposure to the underlying commodity without trading futures contracts or taking physical delivery of the underlying commodity."

However, while some commodity ETFs are focused on a single commodity and hold it in physical storage, others invest in futures contracts.

Darius McDermott, managing director of Chelsea Financial Services, said: "If you want to invest in the actual commodity, you need to look at an ETF, but as some ETFs invest in the physical commodity and others invest in index-swaps you need to be careful and make sure you know which is which."

He sounded another word of warning: investors in crude oil ETFs should beware the 'contango effect'.

"Many oil ETFs track futures contracts rather than the spot price of crude," said McDermott. "When people are willing to pay more for crude oil in the future than they are today, it means you're paying a premium – buying high and selling low. Contango usually occurs during periods of low prices and high production."

Active Funds

Another way of tapping into the fortunes of commodities is to invest in companies which produce them. Instead of giving exposure to the physical commodity, actively-managed commodity funds hold commodity-related equities. A fund could invest in mining companies, fertiliser companies or even machinery companies.

Investing in this way offers the potential to get a leveraged return on your investment as a 10% rise in the commodity price might result in a greater than 10% increase in profits for a company.

"There aren't many of these funds around and each invests in a different way, so you need to look quite carefully," said McDermott.

He likes BlackRock Gold & General and Baring Global Agriculture. The former, run by Evy Hambro and Tom Holl, invests in global shares of companies which derive a significant proportion of their income from mining for gold or other precious metals. It ranks first among gold and precious metals funds over three and five years, but has nevertheless lost a significant amount of investors' capital – around 60% – over those timescales. The latter, managed by James Govan, invests in companies that obtain most of their earnings from activities related to soft commodities (any agricultural good that perishes). It has lost more modest, single-figure sums over three and five year periods.

However, Paul Burton, a mining analyst at QuotedData, pointed to signs of the tide turning on commodities, both from manager sentiment and a slight pick-up in fund performance.

"It's difficult to read the runes on China, whose growth largely drove the previous boom, but it could be that we're reaching a point where growth expectations have rebased and perhaps we could start to see growth again in the not-so-distant future," he said.

"Furthermore, a five-year bear market in commodities has led to projects being delayed and cancelled, which could create a supply drought and consequent price spiking when things start moving again. Of course, time will tell on longer-term projections."

Investment Trusts

There are currently ten commodities and natural resource investment trusts listed on the London Stock Exchange, with a market capitalisation of £1.24 billion, according to the Association of Investment Companies (AIC). The market cap is the number of shares of the trust in issue, multiplied by the share price. (The assets under management is usually higher and reflects the gearing / leverage of the trust.)

These are quite different in nature, targeting different subsets of the resource space and follow varying strategies. Matthew Read, a senior research analyst at QuotedData, the investment trust research firm, said: "They also differ significantly in terms of size and liquidity with some trusts in the sector suffering with extremely restricted liquidity."

Global Resources Investment Trust has a market cap of just £2 million and New City Energy of just £7 million, while at the other end of the scale Riverstone Energy has £635 million invested and BlackRock World Mining £358 million.

"Smaller funds need to be looked at on a case-by-case basis, but those focusing on smaller cap stocks have suffered disproportionately," said Read. "The small caps tend to be exploration companies, which are unlikely to have production revenues to fund future development.

"Exploration is a very expensive business and the big concern is how you fund this in difficult markets, but should demand return these small cap exploration stocks could recover strongly."

The AIC points to two big benefits of the investment trust structure when it comes to investing in commodities. Firstly, the closed-ended structure of investment companies means managers can choose the best times to sell assets, rather than being forced into selling chunks of their portfolios when investors rush for the exit. This can be particularly useful in more volatile areas, such as commodities and natural resources.

Investment trust managers can also hold up to 15% of their dividend income in reserve each year to be paid out during leaner times – a feature that has enabled BlackRock World Mining to increase its yield even during a turbulent time for the sector.