What is the difference between an asset and a commodity?
Answer : All commodities are assets, but not all assets are commodities because assets are wide term.
Volatility and high returns go hand in hand. Assets are a property or something that are of value. There are different types of intangible and tangible things that are assets. However, in the trading and investing world, there are different classes of assets. The volatility of an asset is a huge concern for those that trade or invest capital. The prime variance of the asset is volatility over time. The higher the volatility, the wider the price ranges in terms of long term period. There are assets which are more volatile as compared to others and what makes a market attractive or unattractive is the variance of the market as different investors have a different risk profile.
One of the most important factors, for the consideration of which asset to trade or invest in, is the variance of the asset.
Just about everyone has heard of commodities. They are a unique type of asset, which provide returns that are entirely independent from bond and stock returns. Adding various types of commodity will help one diversify their portfolio of bonds and stocks which help lower the risk of the portfolio significantly and increase returns. Commodities are a rare type of asset which can even hedge from inflation due to their impact on the price of goods.
So what’re Commodities?
In order to understand commodities, one needs to understand what they entail. They can be thought of as raw materials which are used for the creation of consumer goods such as aluminum, silver, gold, natural gas, oil, wheat and cattle. They are available in just about every single industry which is why they are referred to as commodities. One can also find soft commodities which are stored for a shorter period of time such as coffee, cocoa, cotton or sugar.
From the beginning of time, the commodity market has evolved greatly when there used to be a time that farmers would store apples and sell in the market if the prices went up. Then, during the 19th century, the demand grew for standardized contracts to ensure that the commodity prices could be fixed or agreed upon. Therefore, the development began of the commodity futures exchange. These days, options and futures contracts are easily traded on different exchanges in various parts of the glove and deal in a huge variety of energy, metal and agricultural products as well as for soft commodities. The price risk is offloaded to the end users due to the standardized contracts and it helps the commodities producers significantly.
Ever since the last end of the 20th century, the commodities have undergone rapid change as an asset class. The commodity futures indexes were developed as well as the benchmark of the indices with the investment vehicles. Now, investors have the opportunity to select from a range of vehicles in order to invest in futures market of commodities, from notes to mutual funds or exchange-traded funds, which cover the vast spectrum from broad based commodity exposures to single based, and even sector based commodity exposures.
Why Should One Invest in Commodities?
The commodity market is huge and it offers some of the best risk-free returns due to its nature. It is used as a hedging tool in times where the inflation rate is unpredictable and increasing by the day. There are three main benefits for investors if they invest in commodities, namely return potential, diversification and inflation protection. These three are vital for a powerful portfolio.
As commodities are just like real assets, they would reach differently to the changes in economics as compared to bonds and stocks, or financial assets as they are referred to. For example, we know that commodities tend to profit from the rise in inflation, and are only one of the rare asset classes that does. Furthermore, the price of the services and goods increases as their demand increases, and so will the price of the commodities, almost in unison to the changes in demand. Since, the price of commodity rises as the inflation accelerates, it may be best for one to invest in commodities to hedge from inflation.
On the other hand, bonds and stocks perform better when inflation is slowing or stable. When the rate of inflation rises fast, it leads to the lowering of future cash flows value that are paid by bonds and stocks as the future cash would only be able to buy less services and goods as compared to today.
Commodities and Volatility
Active traders are attracted to those assets which have a much higher degree of volatility as compared to investors. More short-term and speculative trading activity is attracted when the price of the asset is highly volatile. Therefore, the markets that experience high price variance are a trader’s paradise as they yield opportunity for the immediate future and on the other hand, they can be an investor’s nightmare as they seek earnings that are steady.
There are different classes to choose from when it comes to the more popular markets that attract different participants. Commodities, currencies, bonds and stocks are the four most popular classes which provide a different range of volatility.
It is due to these reasons that the commodity index of Goldman Sachs, Credit Suisse and Bloomberg has been independent largely from bond and stock returns in the past, and only correlated positively to inflation.
If we look at the period from 1970 to 2015, the annual returns had a low correlation with the U.S. equities on the Bloomberg Commodity Index and there was a correlation that was close to zero with the global bonds. They were however, positively correlated to the US CPI.
Even though the correlation of equities to commodities experienced a pickup after the global financial crisis, it was only the result of the decrease in total demand which impacted many of the asset classes and resulted in a higher correlation between the two. However, since the period, commodities are responding once again to supply factors. It is due to the geopolitical instability, weather that is impacting the price of grains and even natural gas and has influenced mining or crude oil strikes which impacts metals. The factors don’t affect bond or stock market returns more importantly to a similar degree and the correlation between other asset classes and commodities has come down.
The low correlation of commodities to bonds and stocks shows what might be the main advantage of broad exposure and that is diversification. For a diversified portfolio, the movement of the asset classes would be in sync with one another, this leads to the reduction in the overall portfolio’s volatility. The consistency of the returns would be improved over time due to the lower volatility reducing the portfolio risk. It is impossible for losses to occur even with diversification.
Let we compare commodities, equities, bonds and forex volatility :
Shares in companies are included in the equity asset class and so are indices which reflect the overall volatility in the stock market or other sectors within each of the equity class. Trading or investing in the equity market is the most popular option among investors.
Major indices such as the S & P 500 or the Dow Jones Industrial Average normally experience a similar variance over time unlike most stocks which do not experience such a degree of volatility. Stock prices do make significant moves in certain periods. Examples in which stocks were dramatically lowered include the recent global financial crisis in 2008, the stock market crash of 1987 and 1929.
The US is the most stable economy in the world and the US stocks are definitely much less volatile as compared to their counterparts around the globe. The market has ranged from the highs of 27.23 % and lows of 5.35 % since the financial crisis of 2008.
A bond is a debt instrument which provides a coupon or yield to the holder of the instrument. Governments around the globe offer bonds just like companies. Bonds help finance businesses and countries by borrowing from the public. The different periods along the yield curve are looked at in the bond market by traders and investors who are active in the bond market. Short-term bonds are much more valuable as compared to long-terms ones which investors only look at for a steady flow of income.
It is the Federal Reserve or the Central Bank which controls the short end of the yield curve in the United States. The interest rate is the Fed Fund rate which credit unions and banks would lend to reserve balances on overnight basis. The Fed Funds rate is dictated and controlled by the US Federal Reserve. The minimum interest rate is the discount rate which is set by the Fed Reserve in the United States for lending to different banks. Market forces influence the prices of debt instruments and bonds, that have further maturities, and the Central Bank on the other hand controls the Federal Funds as well as the Discount rate.
The long-term and medium rates can be influenced by the short-term rates, but there would be divergences that would happen. Short or long positions can be taken by bond traders depending on how they view interest rates. A short position has a view that the rates would move higher, while a long bond position would bet that the rates would decline. Most of the bond traders position themselves just along the long and shore one maturity and the yield curve to take spread out and take benefit of pricing anomalies. A consistent and safe yield is what investors in the bond market look for in their investment nest eggs. Since the wake of the financial crisis in 2008, volatility has moved higher.
Since the United States is the most stable and richest economy in the world, the dollar is the reserve currency of the world. As compared to most other asset classes, currency volatility is normally lower due to the government controls on money supply and printing into the monetary system. To a large extent, governments control money supply. The stability of a government is what the volatility of currencies is dependent upon. Therefore, the Pakistani Rupee has a higher volatility as compared to the dollar for example. Other foreign exchange instruments can also be less likely to be reserve currencies as they are less liquid. Normally, the dollar index has shown a reading of below the 10 % level.
Coming to commodity volatility, it is the t asset class which tends to be highly volatile. Looking at just the volatility of crude oil, since 1983, it has ranged from over 90 % to 12.63 %. A similar metric is seen for natural gas. If we look at the natural gas variance on a shorter term basis, the range has been over 100% in many occasions which shows just how volatile the commodity market can be for certain commodities.
The volatility in soybeans according to the quarterly historical data has ranged from 10 % to over 75 % since the 1970s. There has been a similar trend for corn and even the sugar futures market as well as coffee futures. Silver has experienced the range from 10 % to more than 100 %. On the other hand, gold is a hybrid commodity since central banks across the globe hold the gold as a reserve asset. The yellow metal has a dual role which is of a financial asset and a metal commodity.
The hybrid nature of the gold prices has been reflected since the middle of the 70s wherein the quarterly volatility has been from 4 % to more than 40 %. This shows us that commodity volatility is high over time due to various reasons and some commodities and more volatile as compared to others.
5 Reasons behind Commodities Being More Volatile
So where is secret ? Let we figure out why commodities are volatile ?
Commodities attract investor interest through the years due to the bull market periods. There has been an increase in choice for participants in the market over the years because of the emergence of new market vehicles which trade on ETN and ETF products as well as traditional equity exchanges. Before their introduction, investors could only invest in commodities that did not have a futures account and could be done through the ownership of the physical commodity.
When traders look at the short-term advantages of commodities, they are keen on investing in commodities. Here are the five core reasons for commodities being more volatile than other asset classes.
There is much less liquidity that is offered by commodities on the futures exchanges. Even though gold and oil can be the most liquidly traded commodities, they can also be highly volatile due to various reasons.
2. Mother Nature
The weather is determined by Mother Nature and so are natural disasters which occur from time to time on our planet. A spike in the price of red metal would cause if there is an earthquake in Chile, as is the largest producer of copper in the world. The prices of soybeans and corn would skyrocket due to a drought in the US. While, the recent cold winters have led to an increase in the demand for natural gas which has led to the energy commodity of the futures contracts skyrocketing.
3. Demand and Supply
At the end of the day, commodity prices are greatly influenced by demand and supply. Demand can be considered constant, while the production of commodities varies due to various reasons such as the climate, soil, and other factors. The demand is ubiquitous and the supply changing from time to time, has led to the asset become highly volatile.
It is almost impossible to leave out geopolitics from commodity variance. When countries go to war or place an embargo on a country that is a major producer, it leads to the prices of the commodity skyrocketing. An example of this can be the sanctions on Russia, Iran and the Iraq-Kuwait war. Wars impact production and affect or even close off logistical routes which make it impossible or highly costly to transport the goods.
Finally, leverage is something that needs to be looked at. Futures do provide a high level of leverage as compared to others, and it impacts the volatility of the commodities.
How Can One Invest in Commodities?
It might have been challenging to capture all of the advantages of commodity exposure in the past. Investors have been provided with another option due to investment vehicles benchmarking with commodity futures indexes and gaining exposure. Commodity exposure helps manage against a diversified index. Asset allocation has been done since the beginning of time which shows that it is beneficial.
Are there any Risks?
Although, diversified commodity exposure does offer investors with various advantages, there are risks to commodities investment. During cyclical downturns, commodities might not perform well and if the industrial and consumer demand slows, there are other things which could impact it such as politics, natural conditions and the market.
One more thing.We see in this text that commodities are Volatile Assets. A lot of people think that volatility is bad thing, something as huge risk. No risk and volatility are different things and volatility can be huge advantage in trading. Just try!