Investing in commodities can help you moderate inflation risk and increase chances of reaching your investment objectives.
Inflation risk is the risk that your standard of living including consumption needs such as buying a house will be affected due to increase in general price levels in the future.
In this article, we discuss how commodity investments can help you reduce inflation risk. This article can be read along with the one titled Benefit by hedging your consumption needs published in this column dated November 18, 2012.
Inflation could cause problems for you for two reasons. One, inflation can lead to decline in investment value. And that would mean you cannot accumulate the wealth that you require to meet your investment objectives. Your investments could decline in value in anticipation of increase in interest rate by the Reserve Bank of India to curb inflation.
And two, even if your equity and bond investments do not decline in value, you may not still achieve your investment objectives. This is because the increase in price level would have increased the cost of your liability.
By liability, we mean future consumption requirement for which you are investing. That is, inflation would increase the cost of the house you want to buy besides your regular household expenses.
What should you do to moderate the effect of inflation on your lifestyle requirements? You should consider adding commodities to your investment portfolio. Why? Inflation can be due to two primary reasons — increase in input costs for manufacturing goods and services and/or supply-side constraints. In either case, inflation essentially means you will experience an increase in the price levels of commodities such as crude, steel and food grains. If you invest in these commodities, you will benefit when their prices move up. And the profit you generate from your commodity investments can moderate the losses you suffer on your bond and equity investments. The question is: How should you invest in commodities?
CHOICE OF FUND
An ideal investment choice for you would be to buy a commodity fund that invests in products affecting typical household such as petrol, electricity, wheat, rice and, perhaps, gold and silver. Unfortunately, you do not have such funds in India yet. Your best course of action at present is to buy futures contracts on such commodities on the Multi-commodity Exchange (MCX). You should invest in futures only if you understand the associated risks.
Alternatively, you can explore investing in US-based commodity exchange-traded funds (ETFs).
The PowerShares DB Commodity Index Tracking Fund, for instance, invests in futures contracts of 14 physical commodities such as aluminium, crude, copper, sugar and wheat.
But why invest in US-based commodity funds? For one, crude, which has a significant effect on your household expenses, tracks global prices. So is the case with other global commodities such as gold. So, investing in US-commodity funds can still help you reduce the inflation risk on your investments. For another, given that we do not have a commodity-based product in India yet, you might as well invest in one outside India that can somewhat reduce your lifestyle inflation risk.
Of course, if the rupee were to depreciate against the dollar, the returns you generate on your US funds will be reduced, if not neutralised, when you transfer your money to India. It will be, therefore, better to discuss with your investment adviser before buying any such US-based commodity products.
Investing in commodities will help you manage your standard of living better. Do not, however, aggressively invest in commodities as such investments tend to fluctuate wildly due to changes in global demand and supply.
So, if you are working and wish to moderate inflation risk, allocate not more than 20 per cent of your total portfolio to such investments. And if you are retired, restrict such investments to 10 per cent of your retirement income portfolio.
(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. Feedback may be sent to firstname.lastname@example.org)