Taking advantage of the opportunity to add commodities to your portfolio

Performance drivers The fundamentals driving commodity price rises are typically thought to be primarily the result of increasing demand. The perception that recent performance has been driven by the strong demand for commodities from Asia, in particular China, is true but forms only part of the story. More importantly, the severe supply-side capacity constraints that many commodity sectors are facing have been an important contributor to the rise in prices. This capacity constraint has been fuelled by the lack of investment over the 1990s in the production and transport of many commodities. These capacity constraints should persist, as many commodity producers have only recently started to reverse a decade-long trend of under-investment in the extraction, transformation and transport of raw materials. Building new supply into a number of the different supply chains, be it energy or metals, is a slow business and that is creating a bottleneck that is forcing prices higher. Strategic investment Having once been thought of as a relatively speculative vehicle for high risk investors, commodities are now positioned as an important strategic investment and are now open as an opportunity for a much broader investor base. The argument for investing in commodities is that they not only provide access to potential equity-like returns, but also provide strong diversification. It is clear that commodity markets behave differently to those of bonds and equities. For investors with large bond and equity holdings, commodities are an important diversifying agent that may help to reduce the risk profile of the portfolio as a whole. Commodities also potentially provide a good hedge or diversifier in periods of turmoil such as natural disasters or wars, in addition to offering an attractive source of return. Unlike traditional asset classes, commodities are not adversely affected by inflationary pressures and generally enjoy a positive relationship with inflation. It is often the case that shocks to equity or bond markets cause these to move in opposite directions to commodities. How do you invest in commodities? There are three main ways of gaining commodities exposure in your portfolio:

• Passively: an exposure to a commodities index;
• Enhanced index: investing in a strategy which seeks to generate a return above the index to remove the drag of fees;
• Actively: this often involves the trading of individual commodities or sub-sectors with tactical asset allocation between types of commodities.

There are advantages and disadvantages of each approach which investors will need to individually consider. What is clear is that the role of commodities as part of a balanced investment portfolio has evidently coincided with the increased flexibility of Ucits regulations, enabling much wider availability. Consequently, for institutional investors with large bond and equity holdings, commodities are a great diversifying agent that will help to reduce the risk profile of their portfolios as a whole.