Wednesday, December 02, 2009

How To Diversify Investments During Time Of Crisis

AS a result of the financial crisis, even though most commodities have not been performing well, gold has outperformed the conventional asset classes like equity and bond.

This has prompted some investors to consider commodities as one of their investment asset classes. In this article, we will look into how to invest in commodities.

Bruno H. Solnik and Dennis W. McLeavey in their book titled “International Investments” classified commodities in three major categories – agricultural products, energy and metals.

Examples of agricultural products are fibres (wood, cotton), grains (wheat, corn, soybean), food (coffee, cocoa, orange juice) and livestock (cattle, hogs, pork bellies). Energy products can be crude oil, heating oil and natural gas whereas examples of metal products are copper, aluminum, gold, silver and platinum.

The main reason behind investing in commodities is that they have negative correlation with stock and bond returns. This will provide a good way to diversify portfolio risks. Besides, given that commodities are positively co-related to inflation, they can help investors hedge against inflation.

Investors can consider investing directly in commodities or indirectly by buying into futures contracts, bonds indexed on some commodity price as well as stocks of commodity related companies.

Some companies will invest in commodities that are extensively used as raw materials in their production processes. High commodity prices or raw material prices will affect those companies’ performance. However, if they have invested in their raw materials, even though their profitability might be affected by high raw material prices, the gains from their investment in those commodities will offset the losses in their operations.

Some investors will consider buying into commodity futures, such as crude palm oil (CPO) futures as this is one of the easiest and cheapest ways to get exposure to commodities.

However, investors need to understand that futures trading requires a high level of trading skills as most commodity players are well-equipped with the required market information, like total world supply and demand of CPO as well as the weather conditions in those producing countries.

Some financial institutions may offer unit trust funds that invest directly in those commodities or indirectly through buying into commodity futures. In the United States, investors can buy into commodities via exchange traded funds (ETF) that are invested in commodities futures.

An ETF is a special type of fund that tracks some market indices and it is traded on a stock market like any common share. Given that the world economy may recover further and oil prices may go beyond US$100 per barrel again, buying into oil or other commodity related ETFs may provide retail investors an alternative to get exposure into commodities.

Since commodity cycles and the general business and stock market cycles are usually different, investing in commodities provides a good way of portfolio diversification.

Besides, investors can consider buying into collateralised futures funds (sometimes they are referred as structured products). A collateralised futures fund is a portfolio that takes a small long position in commodity futures and invests the rest of the money in government securities. Normally, it is capital guaranteed as the yield generated by government securities will be used to cover for the cost incurred for the futures contracts.

Lastly, investors can consider buying into listed companies that are commodity related. In Malaysia, if investors wish to gain from higher CPO prices, they can consider buying into plantation companies.

Given the current gold prices of more than US$1,150 per ounce, some investors are eager to know whether there are any further upsides to the gold prices. Some analysts and fund managers have predicted that the gold prices may go beyond US$1,200 to US$1,300 per ounce.

Investors will rush into gold during a financial crisis, like the current financial crunch and the Great Depression in 1929-32, because gold can keep its value during those periods.

We believe that gold is a cyclical product. Even though nobody knows how high the gold prices can go, given that the world economy is showing signs of recovery, the upside potential for gold investing may be limited.

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