Commodities. They’ve had a tough run for years. Until recently, they were something few would consider including in a portfolio. Their five-year bear market began in 2011, and it seemed to hang on forever. But last year, things began to shift for this black sheep of an asset class. Emerging markets gained strength, and the dollar weakened—both of which bode well for commodities prices. It’s a long-overdue cyclical upswing, but commodities are now in the midst of a bona fide rebound. Their recent performance begs the question: Has the time finally come to reintroduce commodities into your client portfolios?
Looking at the big picture, the answer seems to be a pretty clear “yes.” From an asset allocation perspective, the timing couldn’t be better. With the equities market soaring, investors are seeking greater diversification to help ease volatility. Commodities can play well in this scenario because commodity prices are often uncorrelated with the prices of stocks and bonds. If stocks and bonds were down, commodities have the potential to be up. If you have been including some commodities in your portfolios, chances are you are currently overweight in oil and energy—and drastically underweighted in other potentially beneficial commodities—as many commodity funds weight their assets by production or market cap. As always, diversification is key, and increasing your exposure to a larger menu of commodities can help your portfolios and your clients’ long-term outlooks.
If you haven’t looked into commodities for a few years, you may think of commodities trading in one way only: futures contracts. If that was indeed the only method, no one could fault you for feeling daunted by the prospect. Futures contracts present a variety of challenges for advisors. Each contract requires a separate minimum deposit, and the value of the account increases or decreases as the value of the contract changes. If, as often happens in commodities, a dramatic shift occurs and the value of your contract plummets, the resulting margin call will force you to add money to the account simply to maintain your position, all of which increase the cost of carry. Roll also comes into play. As each contract nears expiration, it must be rolled over to a different month to avoid the costs and obligations of settlement of the contracts. (No client wants 10,000 pounds of pork bellies landing on their doorstep!) If the futures price on the next month’s contract exceeds the price of the expiring month’s contract, the commodity is said to be trading in contango. Investors are likely to then lose money as part of the “roll” process because the new contract they are purchasing is more expensive than the expiring contract they are selling.
If you haven’t run away yet, here’s your reward: there is a way to invest in commodities that is less complex, less costly, and can help diversify your portfolio immediately. The method? Investing not in futures contracts, but instead in the stocks of companies whose business lines are tied to a specific commodity. It’s as simple as investing in any equity.
Take oil as an example. If you invest in futures contracts to gain exposure to oil, you face all the complications of roll, contango, and carry. In contrast, if you invest in these companies’ stocks, the investing process is straightforward. If oil prices rise, the company’s stock prices tend to go up. If oil prices fall, stock prices are likely to drop. Either way, there is no margin call, no cost of carry, and no need to manage the roll of a futures contract. Another benefit is that by owning the stock, you can potentially receive dividends from the stock, which means you have a positive cost of carry with equities as opposed to a negative cost of carry for futures. The same concept is true for other commodities that are currently underweighted in most investors’ portfolios.
Another advantage to the equities approach is that you can gain exposure to commodities that simply aren’t accessible through futures contracts. The ability to invest in commodities such as timber, coal, and water opens the door to greater diversification, and may help opportunity for growth. These smaller sectors that are often missing or very underweight in a commodity portfolio can be very meaningful contributors to returns, and therefore should be closer in weight to the energy and precious metals which often dominate commodity funds.
For anyone seeking to manage risk and volatility, investing in commodities can make great sense at the moment. By investing in equities rather than futures contracts, you can streamline the process.
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The information and opinions herein are for general information use only. The opinions reflect those of the writers but not necessarily those of New York Life Investment Management LLC (NYLIM). NYLIM does not guarantee their accuracy or completeness, nor does New York Life Investment Management LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice and are not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice.
All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market. Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.
Commodity: Investments in instruments and companies that are susceptible to fluctuations in certain commodity markets. Any negative changes in commodity markets (that may be due to changes in supply and demand for commodities, market S-4 events, regulatory developments or other factors) could have an adverse impact on those companies.
There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. There can be no assurance that investment objectives will be met.
Contango is a situation where the futures price of a commodity is above the expected future spot price.
Futures contract is a legal agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future.