Physical commodities: a solid way to boost returns and cut risk

Commodity prices have been shooting up for some time now, but they have much further to run yet. Find out why - and learn more about the best ways to invest.

The recent spike in the oil price to $70, caused by Hurricane Katrina, has drawn further attention to the dramatic performance of commodity prices. Does this mean investors should be buying commodities, or is it too late? I believe there are two basic reasons why you should still be investing in physical commodities.

First, the evidence suggests that commodities still have a lot further to go in terms of price performance. Second, commodities are a different asset class from shares (including shares in mining firms). By adding them to a portfolio of equities and bonds, investors can increase expected returns and reduce risk in their portfolios. Not a bad bet.

Commodities are still cheap

Commodities are still historically cheap. To forecast where commodity prices may be heading, it's important to understand that, despite their recent strong performance, commodity prices, after adjusting for inflation, remain near all-time lows, on a 200-year scale. Economic growth during the last decades of the 20th century was dependent on the more mature OECD economies of the US and Western Europe, creating two key trends that contributed to weak demand for commodities: miniaturisation, and growth of the service economy. We started demanding smaller, lighter, more compact electricals and substituting plastic in place of metal. Also, much of the additional spending in Western economies went towards services, such as holidays and health clubs. These developments have meant 30 years of weak demand for fuel and minerals.

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Nonetheless, commodity-producing countries persisted in maintaining supplies. Zambia and Chile, for example, whose economies were critically dependent on dollar-denominated exports of copper, were prepared to keep mines open as long they could cover the marginal costs ofproduction. Such persistent over-supply inevitably created disequilibrium in commodity markets, resulting in falling prices.

But they're going to get dearer

But now there is a robust bull' case for commodities, which suggests markets may have reached a floor and that we're likely to see a continued rise in prices. In the first place, recent years have seen the dramatic emergence of China, India, Brazil and Russia as major commodity consumers. China's economic growth rate has made it the world's largest importer of copper and aluminium and the second-largest oil importer. Since 1995, China's oil demand has more than doubled to over six million barrels a day, overtaking Germany and Japan as an oil consumer. And its consumption is still rising.

And emerging economies' appetite for commodities is likely to keep growing at high levels for years to come. They all still need major infrastructure development in the way of roads, power and water supply, which is very heavy on consumption of commodities and lasts for years. In time, the substantial middle classes in these economies will start to become a meaningful engine of consumption. Middle-class demand is very much focused on consuming goods, with housing, cars, fridges as well as power and water being high on the agenda. All these rely heavily on commodities for their production. A second point to note is that the oil component in these newer locomotives' of the world economy is still very low. China consumes only 1.5 barrels of oil per capita per year, compared with 10.4 barrels per person in the UK and nearly 26 barrels in energy-profligate USA. India consumes less than one barrel a year per head of the population. With their vast and growing populations more than 2.5 billion combined both India and China will require rising quantities of oil to support their economic growth. Even at GNP growth rates far lower than what we have seen in the last year or so, this would mean a dramatic increase in demand for oil.

The trouble with supply

Faced with the reality of falling real prices over recent decades, most multinationals responded by cutting back on expenditure remember the 1990s, when downsizing' was the management buzzword? Mining firms were in the vanguard of this effort, with drastic reduction in expenditure on exploration, as well as cuts in investment on refining capacity, building and maintaining infrastructure. Experienced staff were laid off in large numbers, and research and development budgets cut.

Now, with the surge in demand, supply is struggling to catch up. The nature of commodity supply is that it requires years of investment to bring new supply on tap. Lead times can be five years or more for bringing new mines on stream. This, combined with low investment for many years, means we will not see any short-term surge in supply, despite the recent commodity-price hikes.

Commodities markets are unlike financial ones because, of course, they're physical. It takes longer for commodity markets to come back into equilibrium, and bull markets typically last for decades, not months. JP Morgan Fleming is forecasting that the current bull market will last for another 20 years. I agree that the commodities story is still young and has years to run. Still, in addition to the very realistic prospect of making good returns, there is another equally powerful reason to invest in commodities.

A different kind of asset class

Physical commodities are a different asset class with different characteristics from shares and bonds. Historical research on the returns offered by commodities futures shows that:

- Investing in physical commodities has given investors better returns than holding shares in comparable mining firms.

- Commodities give investors a positive return when shares are not performing well, and serve as a hedge against falling stockmarkets. You can therefore improve the potential return and reduce the risk in a portfolio of shares and bonds by adding exposure to physical commodities.

How to invest

Buying shares in mining companies is easy, as is buying into an equity fund that gives exposure to the shares of mining companies. But research shows that the physical commodities give better returns than the shares, and have an added diversification benefit that shares do not provide. So, how can you get exposure to physical commodities without ending up owning a warehouse full of copper? Here are a few of the more established routes.

- As MoneyWeek readers will know, spread betting offers one of the easiest ways into physical commodities.You can bet as much or as little as you like on each point. And you can bet on anything, from oil and gas to industrial metals and gold. As you don't have to pay capital gains tax or commission, they are also a cheap way into commodities. But they're usually only for short-term bets, so are not necessarily the right method if you want to ride the long-term bull market.

- Another similar option is contracts for difference, which are derivatives similar to spread bets, but with different tax arrangements (while you do have to pay capital gains tax, you can offset losses against your overall tax bill, making them more suitable if you're investing big sums). In general, you can only get commodity exposure using contracts for difference for a three-month period. So if you want to take short-term trading positions on particular commodities, you may favour this approach. It may not be so good for long-term investors, however.

- Covered warrants. Again, these are derivative contracts, listed on the London Stock Exchange. They allow investors to gain geared exposure to different individual commodities, or to the Goldman Sachs Commodities Index. They all have set expiry dates and, being derivatives, could expire worthless.

- Gold Bullion Securities. Investors receive shares in a firm that buys and deposits physical gold to match investors' positions. They're suitable for people taking a specific view on gold. But gold is not the most direct beneficiary of the infrastructure development in less developed countries.

- Finally, there are funds that can give you an entry into the world of commodities. Unfortunately, while there are a number that invest in commodities-related equities, few invest in the physical commodities themselves. One that does is my Dawnay Day Quantum Protected Commodities Series, a five-year capital-protected investment, with a one-off initial fee of 7.5% (there is no annual fee). The fund has two investment options, giving capital protection of 100%, or 90% at maturity, and offers investors 1.5 times, or 1.8 times the capital growth in a portfolio of physical commodities at maturity. An alternative is the Diapason Rogers Commodity Index fund, which attempts to replicate the performance of the Rogers International Commodity Index. However, the minimum investment is $100,000. Other funds specialise in one commodity. For example, there is Brent Oil Securities, which allows investors to invest in the oil market without the need to take delivery of barrels of the black stuff.

In conclusion, there are a number of ways to gain exposure to physical commodities, depending on your appetite for risk, your investment horizon, and the degree to which you wish to take on exposure to a single commodity. The one thing that's clear to me is that the medium or long-term view for commodity prices is positive, and this is an asset class that institutional and individual investors will all come to hold in their portfolios in the years ahead. As ever, the early birds are most likely to get the fattest worms.

Mark Mathias is managing director of Dawnay Day Quantum. For more information, please visit: