Investment in Commodities in India – 6 Tips
Investment in Commodities have become a more mainstream investment class in the last decade, primarily due to the fact the commodities have performed much better than other investments. Today, investors have many new sources to invest in commodities.
Yes possible, but most of us just think about gold or silver only when it comes to Investment in commodities. If one looks closer there are dozens of options under commodities to choose from. Lets go through an anecdote to start with.
Commodity Chit Chat
Mr.Ramesh, a Mechanical Engineer meets Mr.Bhavesh, an investment analyst from a leading broking firm. Ramesh talks to Bhavesh about commodities and wants some advice. Their conversation goes like this….
Ramesh: Last time we discussed about Gold, but I found that it’s been a good investment for past few years and prices touched record levels of Rs.30,000 per 10gms last month (June 2012). Will there be a fall in gold prices?
Bhavesh: Yes, but remember that gold prices are highly volatile and you need to plan and allocate about 10-20% of your investment in gold. Gold in international markets touched an all-time high of $1923.7 per ounce on 06th September 2011 and as of July 2012 its been trading in the range of $1550-$1600.
Ramesh: Is there are way to invest in other commodities?
Bhavesh: Yes there are several options within for investment in commodities. You can trade or invest in other precious metals such as silver, platinum or even consider agricultural commodities such as soya oil, turmeric, guar seed, etc.
Ramesh: Hey Bhavesh, I wanted to know how to invest or trade in different commodities and its benefits? Tell me when you will be free to discuss this.
Bhavesh: How about meeting this Saturday evening?
Then on Saturday Ramesh and Bhavesh meet and they discuss various options or avenues regarding Investment in commodities.
Ways to Invest in Commodities?
There are various ways to invest in commodities. However, each route has its own pros and cons, so one has to assess and choose the route the most convenient and effective route.
Lets loot at various options and see how they work.
1. Investing in the physical form
There are many people who invest in physical commodities such as jewellery, coins, bars, etc. which is quite common in case of precious metals such as gold, silver, etc.
However, when it comes to agricultural commodities or base metals (steel, nickel, etc.), it is practically not possible to physically buy, store and maintain such commodities.
Point to note
Most common people would be able to store some precious metals for ornamental or investment purposes but this has its own limitations. The storage cost, maintenance and safety issues can make it impractical for most people. So this option works for a few precious metals only.
2. Use of Commodity Futures
Lets say Mr.Ajay expects Gold prices to go up in the next six months. To gain advantage of this trend he can buy gold futures at current price (say Rs.29,500/10gm). Over the next two months if prices move to Rs.30,500/10 gm Ajay will have made a notional profit of Rs.1000/10 gm. If Ajay sells and closes out his trade he gains Rs.1000/10 gm. This is how commodities futures works.
Similarly if someone expects gold prices to fall, he or she can sell the futures contract and buy it back at a lower price.
There are different commodities exchanges in India such as Multi-Commodities Exchange (MCX), National Commodities Exchange (NCDEX), National Multi Commodities Exchange (NMCE), etc.
Point to note
This option is good for short or medium term investors or traders who want to take a call on the future price movements. This may not be suited for pure long term investors.
Although commodity trading isn’t rocket science, one requires knowledge, experience and acumen to spot emerging trends of different commodities and the ability to capitalize opportunities.
For instance for a commodity such as copper one must have some idea of copper’s application across industries, total demand and supply trends, large producing countries, large consumers, etc.
Since each commodity has its unique nuances it would take time for retail investors to become adept at commodity futures. Unless one is well-versed and has some experience in this market this option is not recommended.
3. Use of e-series products (e-gold, e-silver, e-copper, etc.)
National Spot Exchange Limited (NSEL), a national level, institutionalized spot market came up with an new set of products known as “e-series”. E-series provides a novel and affordable way for retail investors to invest in commodities.
For example investors can buy 1gm of gold or 100 grams of silver or 1 kg of copper.
Point to note
To use this facility investors have to open a demat account with their depositary participant, who is empanelled with NSEL. This option would suit investors who want to have a separate account for investment in commodities. But having an additional account solely for this purpose would be an additional cost.
4. Investment in Commodity Stocks
This is a perfect option for equity investors who want to get exposure to commodities through commodity stocks. By investing in commodity stocks you are betting on the performance of companies that are in to mining or manufacturing of commodities such as aluminium, iron, steel, copper, silver, gold, etc.
For example there are large reputed names such as Hindalco Industries, Sterlite Industries, NMDC, Tata Steel, etc. which are in to mining and/or manufacturing of several industrial metals.
Point to note
Investors have to clearly understand whether the company is a producer of the metal or a user who adds value by converting it in to other forms.
For instance Sesa Goa is a leading iron ore producer, whereas Tata Steel is a major iron ore consumer that use iron ore as a raw material to manufacture steel. In this case if iron ore prices increase significantly it will be favourable and positive for Sesa Goa, but unfavourable for Tata Steel.
Sometimes the commodity prices may go up which may not get reflected in company performance because of the nature of contracts, labour issues, local laws, other operational hassles, etc.
However, this is a good option provided you choose a reputed stock and have the willingness to absorb volatility and seasonality of commodity prices.
5. Commodity Exchange Traded Funds
In the past few years retail investors have turned to gold in various forms, but Gold ETF seems to have grown at a fast pace.
More and more investors are turning to gold as a way to diversify their portfolio beyond stocks and bonds, which are vulnerable to financial uncertainties.
In Indian we have only Gold ETF under commodity ETF category. There were some proposals to launch Silver ETFs, but it has been put on the backburner due to various regulatory issues and lack of clarity.
This is in absolute contrast to developed markets which have ETFs for dozens of commodities including precious metals, agri-commodities, base metals, oil, etc.
6. Commodity Fund of Funds
Some funds have found a new route where they provide an option for investors to take exposure to international commodities fund through a feeder fund in India.
For example there are funds like DSP Black Rock World Agriculture Fund and DSP Black Rock World Energy Fund, to name a few.
These two funds invest in their respective parent funds abroad (with a similar theme). Hence, the returns are closely linked to the parent fund performance and the rupee-dollar exchange rate.
Currency risk can also be significant because when you buy these funds, the investments from you will be converted in to dollars and later converted back in to Indian rupees upon redemption.
In addition to these you also have fund management fees and charges to incur. Given these risks, these funds can be avoided unless one is strongly convinced that these are going to add value and help diversify your portfolio in a better way.
In a Nutshell
After all the details above, you will be wondering which option to choose. From a lay investor or AAM AADMI point of view I would suggest the following.
- Tip #1 (Physical commodities) has its practical limitations as individuals cannot hold or store large quantities. For investment purpose this should be avoided.
- Tip #2 (Commodities Futures) is a trader’s game so its not the right place for investors.
- Tip #3 (E-Series) is okay to consider if the investor is willing to open a separate demat account for this purpose
- Tip #4 (Commodity Stocks) can be considered however, there are risks of volatility and seasonality of commodities.
- Tip #5 (Commodity ETFs) are recommended.
- Tip #6 (commodity fund of funds) have to be avoided.
Conclusion – Investment in Commodities
Given the option available above investors can make an informed choice out of options 3, 4 & 5 depending on their requirements. However, as and when regulations and product features change the other options can be reviewed to check for suitability.
In today’s inflationary environment getting an exposure to commodities is a good option because these have solid physical value, which is purely based on demand and supply in the economy.
The prices of most agricultural commodities have seen consistent increase as the land availability and productivity is dwindling.
Similarly energy based commodities such as crude oil, natural gas, etc. have a bright future as the demand for energy is expanding across the board. Given these trends, allocating a portion of your investments towards commodities will help you diversify as well as add more flavour to your portfolio.