Investors sometimes have the apprehension that investing in commodities is complex and risky. An investor might think that such investing requires owning the commodity and having access to storage. This is not necessarily true. Financial instruments, including commodity derivatives, offer investors a chance to invest in this asset class without having to worry about physical delivery of the commodity, which can indeed often be unnecessary and costly. However, trading in commodity derivatives encounter the obstacle of contracts’ expiry: derivative contracts come with an expiry date and for the investor to have continued exposure to the commodity, they must re-invest or ‘rollover’ the contracts nearing expiry to contracts that are further from expiration.
Indices offer investors an easy avenue to invest in the market of commodity derivatives. The ease of this route lies in that investors have to base their investment decisions only on the expected movements of the index, without having to worry about other paraphernalia associated with commodity derivatives trade. Thus, investors can benefit from the performance of the index without having to deal with roll-over or handling delivery on expiry of the derivatives contracts traded on an exchange. Additionally, commodities in a broad or composite index are often not highly co-related to each other and therefore the index returns are less volatile than the returns on individual commodities. Thus, commodity index provides an investment tool which not only offers effective diversification to a portfolio but also offers an array of risk-return profiles for investors to choose from. This fits quite well in the psyche and investment preferences of the average Indian investor.
So, what are commodity indices? Commodity indices are those that track the prices of different constituent commodities and measure their performance. The components of a commodity index can vary from energy to precious metals, base metals, agriculture or their combination with pre-assigned weights. The performance of the index is tracked through the prices of its constituent commodity contracts and the value of the index linked to the prices of the underlying commodities.
Nevertheless, all commodity indices are not alike. Commodity indices may be broad based including important and liquid commodities from different sectors in a basket, or they may be sector-specific or even single commodity-specific. Even if the composition of two indices are same, differences in the weights of their components may make one more representative, or more profitable for investment, than the other. An investor can invest in commodity indices both directly and indirectly. They can directly trade derivative contracts with a commodity index as the underlying; or they can invest by trading in units of an index-based ETF. Globally, index linked products are also made available by the financial institutions as over-the-counter (OTC) products for the investors matching their risk and return profile.
Commodity index investing through ETFs is the most popular way of getting exposure to this asset class in most jurisdictions where this is allowed. Apart from providing a hassle-free and simple way of investing in commodities, they are offered and managed by institutions which are mostly under the radar of regulatory bodies, which adds to their appeal for retail investors. This makes commodity index-based ETFs popular all across the world. As of July 2017, the total outstanding commodity assets of ETFs globally amounted to $190 billion. Most of these ETFs aim to outperform or replicate a benchmark index.
In developed markets, fund houses employ various strategies in managing commodity-based ETFs, a few of which are mentioned in the accompanying graphic.
The role of commodities as an asset class is widely recognised due to its unique characteristics as a protector against inflation and safe haven nature. With negative correlation to most other financial asset classes, inclusion of commodities in any portfolio enhances the risk adjusted returns and thereby offering a better value to the investors. Commodity indices provide a simple approach to getting exposure to this asset class, which, if accessed with financial instruments which are well-regulated and transparent, can provide retail investors with sound and safe returns. With category III AIFs being allowed by regulators for participation in the commodities derivative markets, they can construct a portfolio in an effort to benchmark the composite index. To the investors in such funds, the movement of the index provides a clear picture of the net asset value of their investments, thereby providing them the with necessary comfort and convenience. Derivatives on commodity indices could also be traded when allowed to provide a risk return profile matching the aggregate movement all underling commodities in the given basket of composite indices; however, tradable commodity indices are not yet available, and when permitted, would provide yet another opportunity for participants to take a basket exposure to commodities and manage risks in a simple manner. If and when institutions such as fund houses are allowed to create and offer ETFs on commodity indices, this would be an opportunity for Indian investors to gain easy access to a new asset class, and thereby, enrich their investment portfolios.
The author is Head, research, Multi Commodity Exchange of India Ltd.