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Pitfalls of investing in commodities

A commodity is not an investment product that you buy and hold for the long term

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In the last 10 years, have been one of the best performing assets, giving high double-digit returns to investors. This is best exemplified by gold, that has nearly quadrupled in value (in dollar terms) since 2003 and was up five times in rupee terms in the last decade. In comparison, the benchmark S&P BSE Sensex is up around 4.7 times since the middle of 2003.

Gold's performance in the last five years has been even more spectacular. In the domestic bullion market, prices have appreciated at a compounded annual growth rate (CAGR) of 18.6 per cent since 2008, much higher than the 4.2 per cent return delivered by the National Stock Exchange's 50-stock Nifty index during the period. The yellow metal has delivered 18 per cent annualised return to investors who held on to their gold holdings in the last 10 years. In contrast, the Dow Jones appreciated at just 2.8 per cent per annum during the period. The picture has not been very different in the last five years either.

  • Commodities don’t pay yields the way equity, bank deposits or property do
  • Most large and established companies pay dividends in line with the growth in their revenues and profits
  • In FY13, 49 of 50 Nifty companies declared equity dividends. This ratio of dividend paying companies is 78 per cent among BSE-500 companies
  • A portfolio of 50 stocks mirroring the currently provides a dividend yield of 1.5 per cent. That is, an of Rs 1 lakh would yield of around Rs 1,500
  • Dividend yields are inversely related to share price
  • In the past 10 years, Nifty companies, dividend payout has grown at a CAGR of 12.4 per cent
  • An initial investment of Rs 1 lakh in a Nifty like-portfolio in 2003 would now yield dividend income of Rs 7,660.
  • Dividend income is tax -free in the hands of shareholders, unlike interest income and short-term capital gains

This has led to huge investor interest in commodities. Most brokerages and fund managers now operate commodity desks that rival and even beat their traditional business in equity broking. For a typical retail investor in India, the case for commodities is strengthened by the stock markets' inability to scale up new highs in the last five years, negative interest rates (when adjusted to inflation) and ever rising commodity prices. This might suggest a new era of investment has emerged, where commodities compete with traditional assets such as equity, bonds and real estate for a share of your savings pool.

Dig deeper and the investment case for commodities is not as straightforward. Unlike equity or fixed income or even real estate, gold, metals or agricultural products don't carry any yields. This means the only way you can recover your investment in commodities is by selling it to others. In many instances, the dividend yield on equity could be significant to begin with or can become large over a period of time if the investor holds on to his or her investment. In the last 10 years, dividend income on a portfolio of stocks that mirrors the Nifty has grown at a compounded annual rate of 12.4 per cent, while initial yield has varied from a high of 3.2 per cent in May 2003 to low of 0.9 per cent in early 2008. At this rate, an initial investment of Rs 1 lakh in 2003 in the portfolio would have yielded dividend income of Rs 7,660 in 2013 (see chart).

If the company whose shares you own doesn't declare dividends (it is a matter of policy and not mandatory), you are still entitled to a share in the company's profit, proportionate to your ownership. In other words, equity is backed by corresponding cash, whether current (dividends) or deferred (retained profits not distributed as dividends).

Ditto for fixed income products such as bank deposits and bonds. All these pay a pre-determined interest to the investor. A house and commercial property provide rental income if you let it out and the owner can choose to live off the income, rather than encash the property.

Commodity investors, however, can't live off their investment and must encash it sooner or later by finding a buyer. This won't be an issue in the normal course but would prove crucial in a sudden and sharp fall in prices as in the late 2008 post-Lehman crisis. This leads many experts to label commodities as dead money. It doesn't pay any interest or dividends and is not expected to shield you from inflation. Besides, commodities cost money in storage, insurance and a management fee if you invest through exchange-traded funds such as gold ETFs. The storage and handling fee in equity and fixed income is minimal.

Commodity traders agree and caution investors about the risk involved in commodity trading. "A commodity is not an investment product that you buy and hold for the long term. It is closer to equity derivatives where you take short-term trading calls," says Kishore Narne, associate director, head-commodity and currency at Motilal Oswal Commodities. However, he says, commodities are less volatile than stocks and, thus, safer. "As it takes time and a lot of resources to produce commodities, prices move in a narrow band," he adds.

The lack of yield also makes it tough for investors to arrive at a fair value. A stock or share can be valued on the underlying (actual or estimated) data on earning per share, dividend yield or book value per share or other such valuation ratios. In a given period, the market value of the share can fluctuate over a wide range on the various valuation parameters, but at every point, investors have visibility about the stock price relative to underlying parameters. This visibility is not there in commodities.

Experts say that just as you do the fundamental analysis in equities, this can be done for commodities. "Commodity prices are purely a function of demand and supply and it's not very difficult to map this equation for an informed investor. Besides, commodity prices cannot move too far from their cost of production," says Narne.

Critics, however, say the demand-supply equation and cost of production is relevant for actual manufacturers and users of the commodity. But more than half of the investors in commodities are now pure-play ones, there just to make a quick gain. "For buyers of commodity futures, the purchase price doesn't matter as long as they hope to find buyers willing to pay a higher price for the contract. More so as commodity trade is typically more leveraged than equity trades," says an equity analyst on condition of anonymity.

In the equity market, a typical investor can leverage his funds by five times. In commodities, the ratio can be as high as 20. This has the potential to exacerbate the boom-bust cycle in commodities.

Commodities have a lower portfolio risk because the return isn't correlated with stocks. According to empirical study by the Wharton School, based on data from 1959 to 2004, commodity futures returns are negatively correlated with stocks; that is, they rise when stocks languish and vice versa. This link, however, seems to have broken due to the large presence of financial investors common across all asset classes. It results in a sell-off in, say, equity or real estate market spreading to all other markets.

For instance, the 2008 Lehman crisis was triggered by a fall in house prices which resulted in a global sell-off in equities, bonds and commodities. Crude oil prices, for instance, crashed by two-thirds, while gold prices halved in months. Then, all assets classes, including equities, recovered in 2009, almost in tandem.

Since then, while the US equity market made a new high, most commodities with the exception of gold failed to scale up their 2008 highs. With the Chinese economy - the biggest consumer of industrial commodities - now slowing, experts say commodities will find it tough to make a new high anytime soon.

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