Why Invest in Commodities? Top 10 Reasons to Know

Trading in commodities is one of the oldest economic activities in human history, where people used to barter goods like grain, spices, gold, and cattle. Over the years, this ancient system has evolved into modern exchanges like the CBOT (Chicago Board of Trade) in the US and MCX (Multi Commodity Exchange) in India, where commodities are electronically traded.

Commodities are an asset class, and investing in commodities helps to diversify a portfolio consisting of only equities. Commodities tend to hedge against loss of purchasing power, have a low correlation with movements in the equity markets, and generally have a low risk profile.

Here are Top 10 reasons why you should consider allocating a part of your portfolio to commodities:

1. Enhanced diversification

Commodities can sometimes behave differently from equities, which can help diversify a portfolio. Gold, in particular, has historically attracted investors during periods of market stress.

During the 2008 financial crisis, while technology stocks were crashing, with the NASDAQ Composite down nearly 42% during the year, gold delivered a positive return of nearly 6%.

During such instances, gold and other safe haven commodities tend to limit the downside risk in a diversified portfolio.

2. Protection against inflation

The simplest reason to invest in commodities is inflation protection. In an inflationary environment where the currency is losing value, the prices of goods and services are also rising. The raw material input costs that go into making the goods are also increasing.

While as a consumer you are paying more for the same product, an investor holding commodities directly benefits from the inflationary spiral as he/she is directly invested in the commodity that is causing the increase in prices.

During 2022, India’s CPI inflation touched nearly 7.8% in April 2022 while the Indian crude oil basket peaked at nearly $116 per barrel in June 2022. A portfolio that directly has exposure to energy and other raw materials was able to offset the inflation-induced negative impact on equity valuations.

3. Ties in with India’s infrastructure push

India’s heavy capital expenditure on its infrastructure development has direct implications for commodities. India’s road, rail, smart city, and renewable energy projects will require copper, aluminium, zinc, and other metals. Allocation to commodities can directly benefit from the India story without having to bear the risk of individual stocks.

4. Protection against Indian Rupee depreciation

India is a net importer of most of its crude material needs, with global prices denominated in US Dollars. Any depreciation of the Indian Rupee against the American currency increases the local price of import goods.

During 2022, a year of global macroeconomic uncertainty, Indian Rupee (INR) was one of the worst-performing currencies globally with a decline of 11.07% against the American dollar during the year. Against this backdrop, dollar gold prices were range-bound during the year as the US Federal Reserve aggressively raised policy rates to tame inflation.

However, the gold prices traded on the Indian Multi Commodity Exchange (MCX) delivered a return of +11.25% during 2022. Since gold imports in India are dollar-denominated, the plunge in the INR acted as a currency hedge for the investors who bought gold through the MCX.

5. Higher leverage

While buying equities or property, you have to pay 100% of the price to get ownership of the asset. However, in commodity trading, one can leverage up to 20x (buy a contract worth, say, Rs 20 lakh by paying only 5% of 20 lakh = Rs 1,00,000 as margin money to the exchange).

This feature allows the trading/investing community to take exposures worth multiple times one’s capital with a minimal amount of money upfront. This allows the rest of the money to be parked in other income-generating avenues.

6. High liquidity and ease of transactions

Popular exchanges like the MCX and NCDEX see high volumes of trades taking place every day on the exchange with narrow bid ask spreads. Institutional investors and hedgers also play a big role in the commodity markets, which allows everyday investors to easily offset exposure without impacting the price much.

Physical commodities, on the other hand, are highly illiquid with high transaction costs. Gold jewellery, for instance, has to be sold to a local jeweller at a hefty discount considering the making charges and margin of safety a jeweller holds.

Exchange-traded commodity products and electronic trading platforms allow smooth entry and exits without many deductions.

7. Diversification beyond traditional financial assets

Commodities give investors exposure to physical assets such as gold, silver, crude oil and industrial metals rather than company earnings or government debt. This can add another source of return to a portfolio and reduce dependence on equity-market performance.

8. Transparent pricing mechanism and regulation

Exchange-traded commodity derivatives provide a transparent platform where prices are determined by market demand and supply. In India, commodity derivatives are regulated by SEBI, with exchanges such as MCX and NCDEX offering electronic trading facilities.

9. Tied to transition metals need for decades ahead

The global energy transition and the shift towards EVs, solar energy, data centres, AI, etc., will require several metals. For instance, solar panels need silver, battery storage needs lithium, nickel, and cobalt, while the entire power grid needs copper. Allocation to transition metals can benefit immensely from this structural tailwind.

10. Acts as a hedge against geopolitical and other supply disruptions

Equities and bonds benefit from geopolitical stability. Unstable situations like geopolitical wars, embargoes, and blockage of the Suez Canal, etc., have a negative impact on equity prices. On the other hand, commodities benefit from such scenarios as they witness spikes in prices due to fears of supply disruptions. Hence, holding some commodities allows investors to hedge against such macro shocks.

Conclusion

Commodities can be a useful addition to a diversified portfolio. They can provide exposure to inflation, currency movements, global demand and supply trends that are different from those driving equities and bonds. However, commodity prices can be volatile, particularly when investing through futures and other leveraged products. Investors should therefore consider their risk profile and investment horizon before taking exposure.