Commodity Market Best for Long Term Investment

Investor interest in commodities has risen in recent years in line with the spectacular surge in most commodity prices. Many fund houses and institutional investors have time and again reiterated that they have gained or intend to gain from the moderate exposure to commodities. In parallel, the development of new investment vehicles has enabled individual investors also to gain commodity exposure.

Expectations of continued strong economic growth in Asia, which should result in Asian countries’ sustained demand for commodities, may be the driver of the increased appetite for these assets. Interest also seems to be spurred by studies by academics and market analysts that highlight commodities as an effective way of diversifying portfolio risk.

This assessment and interpretation suggest that investors are slowly but sustainably including commodities in their portfolios. Can we however assert that commodities constitute an asset class in their own right? This study suggests they do, given that over the long term, returns on commodity-related investments appear to outperform risk-free returns, seem to have a low or negative correlation with other asset classes and can apparently not be replicated with a simple linear combination of assets.

In addition, unlike stock and bond returns, commodity returns tend to increase in periods of inflation. Moreover, commodities provide diversification benefits, especially in times of financial market. Volatility: between 1959 and December 2004, annualised commodity futures returns rose by 1%for the quintile corresponding to the months in which stocks posted the sharpest falls. Commodity futures therefore appear to provide an effective hedge against stock market declines.

Financial Investment in Commodities

It has been suggested that, in addition to fundamental supply and demand factors, the activity of speculators in financial markets may have played a significant role in contributing to the increase in the level and volatility of some commodity prices in recent years. This section describes the growing presence of financial investors in commodity derivative markets, while the next section examines the evidence of the effect of this growth on observed commodity price dynamics over the past decade.

Financial markets provide a useful complement to physical commodity tips because they allow consumers and producers to hedge their exposures to movements in commodity prices. These markets exist precisely because prices can be volatile, and allow uncertainty about future price movements to be managed. For example, a farmer could purchase a forward contract at the time of planting a crop, to give certainty about the price that will be received upon harvest. Financial investors provide additional liquidity to these markets, and can improve price discovery. In theory, there should be a relationship between futures prices and spot prices determined by the ‘cost of carry’. This is the opportunity cost of buying and holding a good or financial instrument versus purchasing a futures contract for delivery in the commodities.