Commodity stocks are perfect portfolio enhancer and diversifier, and many global investors rely on commodity trading to take an indirect exposure in the commodity market for portfolio returns enhancement and diversification amid negative to no correlation of commodities with the traditional assets such as equities and bonds.
Commodity Investing for Diversification, and Why to Invest in it ?
Firstly, the commodity prices are driven by different economic fundamentals as compared to stocks and bonds, which further gives a portfolio diversification advantage.
unlike many financial assets, commodities have prices that are not directly determined by the discounted value of future cash flows, and commodity prices are not as directly related to change in forecasted cash flows and changes in market discount rates. Instead, commodity prices are evaluated primarily on forecasts of the commodity’s supply and demand.
Secondly, the exposure in commodity provides an investor with a hedge against the inflation risk, which is generally the decrease in the purchasing power of the money or in investing terms is the decline in the value of money relative to the value of a bundle of goods and services.
Nominal commodity prices are generally highly correlated with inflation as commodity forms a part of the definition and computation of inflation. The physical commodities such as oil are an important component of the computation of inflation; thus, the nominal prices of commodities and other real assets would move in tandem with inflation.
However, the nominal and real prices (nominal adjusted for inflation) of stocks and especially bonds tend to be negatively correlated with inflation because inflation raises the discount rates applied to their valuations.
Thirdly, commodity prices are relatively immune to the business cycle as compared to the traditional assets, which may react very differently at different parts of the business cycle. The value of stocks and bonds is derived from expectations regarding long-term earnings or coupon payments; however, commodities are often priced more on the state of current economic conditions and factors regarding short-term supply and demand.
To know how commodity prices link with inflation and other technical terms, and their correlation with each other, Do Read: Is P/E Ratio A Good Valuation Metric To Value A Resource Stock?
However, one should keep in mind that the commodity prices (except usually gold) are often at their lowest when economic activity is at its lowest and at their highest when economic activity is at its highest. Traditional financial assets often perform best when the economy is near a low, but the prospects for improvement are high.
Commodity Investing for Return Enhancement
The second primary motivation for seeking exposure to commodities is return enhancement. Return enhancement may be pursued through alpha (idiosyncratic risk); however, it is not clear whether return enhancement can be pursued through beta (systematic risk).
The primary reason that market participants take on commodity exposure in the pursuit of alpha is to speculate on idiosyncratic movements in the underlying commodity prices, and Investors use technical and fundamental analysis to forecast commodity prices and to identify trades with superior risk-adjusted returns.
To explore more about the return enhancement characteristic of the commodity market, and the basic technical terms used in the commodity investing, Do Read: Things to Be Familiar With Before Fishing for Mining Stocks
Commodities As a Defensive Investment
Fluctuations in aggregate global wealth are an unfortunate consequence of economic activity, and when major declines in aggregate wealth occur, most of the major classes of investments tend to decline in response.
The equity markets around the world tend to be more highly correlated during periods of economic stress than during normal times, which implies that in bad times when the benefits of diversification are most needed, equity markets tend to decline at the same time, and global equity diversification fails to protect the investor.
The major reason that traditional assets often do not provide downside risk protection is that almost all traditional assets react in a similar fashion to major macroeconomic events and most traditional investments do not offer both protection from global turmoil and attractive returns, which in turn, prompts the investor to be drawn to alternative investing.
Hedge funds and other skill-based strategies can be expected to provide diversification by being more market neutral and having returns that are protected from, or even benefit from, market turmoil.
In addition to using skill-based strategies, investors can achieve diversification benefits from the passive addition of an asset class, such as commodities.
The greatest concern for most investors is downside risk, and the abilities of commodities to protect against the downside risk is the most attractive point for investing in the commodity market or their respective stocks.
However, a double alpha exposure of commodity stocks might differ from pure-play commodities; however, the higher returns from them generally compensate investors.
Why Commodity Stocks?
A popular way to gain exposure to commodities is to own the securities of a firm that derives a substantial part of its revenues from the sale of physical commodities, such as a natural resource company.
However, many commodity stocks hold multi-commodity exposure to diversify their own portfolio, which comparatively reduces their correlation with one particular commodity.
To Know how to execute astute judgement and select a commodity stock as per your risk appetite, Do Read: Smart Ways To Invest In A Commodity Stock
There are plenty of reasons for an investor to choose for investing in a commodity stock; however, before that investors should be well aware how the valuation in the commodity market takes place, and what to look for before jumping right into the complex world of the resource sector.
The scope of our previous article on commodities valuation and mining stock might help you in such regard, so here we would like to encourage you to Read: An Investors’ Guide for Commodity Valuation and Mining Stocks.
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