Many individuals are uncomfortable taking direct exposure to commodities through commodity derivatives. Yet, investing in commodities is crucial.

This is because a rise in commodity prices is typically the reason for increase in general price levels. So, investing in commodities can help you cushion the impact of inflation on household expenses. Here, we discuss if investing in commodity funds is an optimal way of taking exposure to commodities as an asset class.

Marker risk

Commodity funds are mutual funds investing in commodity-based companies’ shares. Suppose you have a view that crude prices are likely to go up.

Taking an appropriate position using crude futures is not the same as buying ONGC shares. Why? The goal of going long on crude futures is to capture the near one-to-one movement that futures contract has with crude spot price. ONGC is listed on the stock exchange.

So, the stock is exposed to market risk. There is the risk ONGC may decline in price even if crude prices remain strong. This could happen when large-cap stocks show weak price momentum or when market participants are nervous about stock prices in general because of geopolitical tension or inflationary pressures or health of the world economy.

These concerns may not always have an adverse bearing on commodity prices or their derivatives. So, crude futures may be moving up despite ONGC’s share price declining. This argument is true for Real Estate Investment Trusts (REITs) too.

Suffice it to know these are structures that enable you to earn income on real- estate investments. Yet, these are not a pure bet on real estate. As in the case of ONGC, REITs are also listed on the stock exchange and are, hence, driven by market risk.

Conclusion

A security that is listed on the stock exchange carries market risk, which is more dominant than asset-specific risks. So, commodity funds may not necessarily capture all the gains from commodity prices.

In other words, if the stock market is weak, it is highly unlikely shares of commodity-based companies will consistently perform well, even if commodity prices remain strong.

But as a retail investor, you typically have few choices relating to commodity investments. Buying physical commodities is not meaningful as that would involve storage costs. That leaves you with commodity derivatives or commodity funds.

The latter is simple to understand, once you appreciate that such funds are not a pure bet on commodity prices

(The author offers training programmes for individuals for managing their personal investments)

Related Topics