Commodities As an Asset Class: The Next Big Happening in India

What are Commodities:

A commodity is basically a product that is traded in bulk. They can be a natural resource or any Agri
product. Along with other more traded investing assets like stocks, bonds, commodities are also one
of the major asset classes to invest in.

Generally, commodities are not a good investing asset class for individual investors because of their
bulk nature.

Kinds of Commodities:
 Wheat
 Corn
 Soy Beans
 Cotton
 Lumber
 Sugar
 Precious Metals like Gold
 Domestic and Foreign Currency
 Coal
 Oil

Same Grade Commodities are fungible. This basically means that they can be swapped with each
other. For e.g. If high-grade high-quality copper is produced in State 1 and same quality copper is
also produced by State 2, then it does not matter to the buyer from where he should buy the
copper. Thus, copper here becomes fungible.

The global financial market has become one of the most important indicators of economic growth.
Each asset class is equally important in the global economy's growth. Equities, bonds, currencies,
and commodities are all major asset groups with significant contributions to the global economy.

Commodities are a unique asset class with returns that are generally unrelated to those of stocks
and bonds.

As a result, broad commodity exposure can help diversify a stock and bond portfolio, thereby
lowering total portfolio risk and increasing profits. Commodities can operate as a hedge against
inflation because of their impact on consumer goods pricing. Commodities and other asset classes
such as equities and bonds have historically had an inverse association. This feature will allow
investors to include commodities in their portfolios, resulting in a more balanced portfolio.

How Commodities Work:

A futures market is where commodities are traded. The people who make the goods and the ones
who buy them haggle for payment in this market. These contracts also include a future delivery date
for the products.

Soft commodities, which are often farmed crops, and hard commodities, which are derived via
mining, are the two types of commodities. Commodities can be purchased in a variety of ways. For
example, futures contracts, commodity-based mutual funds such as natural resource funds,
basic/true commodity funds, index funds, and so on can be purchased.
Farmers and miners who produce items are examples of commodity traders, purchasers and users of
goods are also examples of commodity traders. Commodity trades come in a variety of forms.

A farmer in Uttar Pradesh may choose to sell his corn on the futures market ahead of time. He
obtains a contract to sell to a buyer at a predetermined price on a predetermined date. That way, if
corn prices fall between planting and the time, he's ready to sell his maize, he won't go bankrupt.

An airline might also use a futures contract to purchase gasoline at a fixed price. This enables the
airline to avoid price fluctuations in crude oil and gasoline.

A corporation that runs a chain of coffee shops might acquire a lot of raw coffee. This can be used to
brew branded coffee in the future. Because the purchase is made at today's pricing, the cost of
producing branded coffee will be more constant.

Advantages of investing in commodities:

Diversification is one of the key benefits of investing in commodities. Profits from commodities are
typically low or negative in conjunction with profits from other main asset groups. This is because
when the price of products and services rises, so does the value of the commodities required to
generate those goods and services. Investors might profit from the market boom by keeping some
commodities in their investing portfolio. Factors that affect stocks and bonds do not have the same
impact on commodities. Furthermore, commodities may react differently to different financial and
geopolitical circumstances.

Event Risk Hedge:

Commodity investing provides a stronger hedge against event risks like war, natural catastrophes,
and financial crises. For example, during a conflict, supply disruptions raise the likelihood of price
increases in commodities such as oil and food grains. As a result, these commodities can be used as a
possible hedge against event risks.

Investing in commodity markets has more liquidity than investing in assets such as real estate.
Commodity futures are simple to buy and sell, and investors can liquidate their positions at any time.

Lower Margin and Longer Trading Hours:

If you want to invest in commodity futures, you'll need to deposit margin money with the broker. It
typically varies from 5% to 10% of the total contract value. This is significantly less than the required
margin for other asset groups. As a result of the decreased margins, investors can take larger stakes,
thereby increasing their earnings.

Another benefit of investing in commodities is that the trading hours are longer than those of the
stock market. For non-agri commodities.

Leverage Benefit:
The benefit of leverage is the first large advantage with commodities futures. When you open a
trade in commodities futures, you simply have to pay a little margin to get started. The margin is
often made up of a SPAN margin and an extreme loss margin. This is usually approximately 5-6
percent in commodity futures, giving the trader a leverage of nearly 20 times. As a result, even with
a little margin investment, one can trade commodities.

Liquid Investment:
Futures on commodities are particularly liquid. Crude oil, gold, silver, mentha oil, cardamom, nickel,
zinc, and copper, to name a few, are all exceedingly liquid. Large transactions are straightforward to
conduct and do not have a significant impact cost. These commodity futures, unlike physical
commodities, are standardized and can be kept only for investment purposes. Commodity futures
allow you to invest in commodities without having to take actual delivery, making them more
affordable and convenient.

Inflation Hedge:
Commodities are a wonderful way to protect against inflation. Commodities are typically included in
most inflation indices. The inflation index, for example, includes both agricultural and non-
agricultural components. Futures can be used to participate in the growth in price of these
commodities. As a result, it acts as an automated inflation hedge. In reality, among the major asset
types, commodities provide the best inflation protection.

Disadvantage of investing in commodities:

Among all asset classes, commodities are the most volatile. Commodities, according to an empirical
study, are twice as volatile as stocks and four times as volatile as bonds. For some conservative
investors, this volatility makes commodities extremely risky. On the one hand, it gives you a better
chance to benefit. It's a high-risk, high-reward investment at the same time. It's also not a good idea
to have too many commodity assets in your portfolio.

To summarize, if you want to diversify your portfolio beyond stocks and bonds, investing in
commodities may be the best way to do it.

Factors influencing the investor sentiment towards commodities:

Due to the dominance of sentiments, investors frequently make illogical investment decisions. As a
result, it is critical to differentiate and classify the numerous elements influencing investor
sentiments, as well as to appreciate their implications on investment decisions.

Sentiment is an important economic indicator since it influences the business cycle and market
volatility. Traditional financial theory asserts that persons who invest are logical wealth maximizers
because they design investment strategies based on basic financial rules that take risk and return
into account. However, in practice, the risk levels of investors are not equal and are mostly
determined by personal risk appetites. Retail speculators, according to financial researchers, are
constrained by external imperatives, such as market-related considerations, which cause individuals
to behave irrationally.

The factors behind the investors’ sentiment which can impact the decision making are:

 Psychological factors: Overconfidence, greed, and fear are all psychological characteristics
that influence financial decisions. Personality characteristics are a mix of cognitive,
emotional, and motivational traits that influence investing decisions. Feelings like fear,
greed, panic, anxiety, fulfilment, and aspiration, which are all part of the human emotional
complexity, play a role in financial investing decisions to a certain extent. The psychological
and emotional state, as well as mood swings, influence investment decisions to acquire, get
rid of, or adhere to. Investors encourage information that supports their beliefs and reject
information that contradicts them, resulting in biased decisions. When investors make
 assumptions or draw conclusions based on small samples, they may incorrectly classify
assets as profitable. Representativeness is the term for this concept. It's a tendency to
become increasingly optimistic about recent successes and increasingly pessimistic about
recent failures.

 Market Factors: Market elements such as the investor's market – bull/bear market, market
trend – up/down in the short/medium/long run, market transparency /non transparency,
market returns, and so on. The market is experiencing or will experience economic
recession/bloom, as well as fundamental and technical aspects of the financial market.
Existing stock fundamentals, stock history trends, over-reaction and under-reaction to price
movements, consumer preferences, and market knowledge are some of the most important
market-based elements. Stock prices are influenced by investors' irrational opinions.

 Economic Factors: Real GDP, corporate profitability, inflation, interest rates, and economic
fluidity are the elements driving investor attitudes. Investors' investment decisions are
influenced by macroeconomic factors such as inflation, interest rates, and the strength of
the Indian economy. Inflation and cash inflation have a big impact on stock market results.
It's difficult to predict the impact of actual macroeconomic variables on overall equity
returns. The stock market is regarded as one of the leading indicators of economic growth.
Investor sentiment in the stock market is influenced by macroeconomic issues.

 Awareness: Media, the internet, social interaction, and private information suggestions all
fall under the umbrella of investment awareness. "The ability to make educated judgements
and effective decisions regarding the usage and management of money" is defined as
"financial awareness." Generally, investors invest based on the recommendations of friends,
brokers, and relatives, or based on the impact of particular websites or news channels.
Media, the internet, magazines, and friends are the key sources of awareness. Investor
awareness is a critical component in determining investment behaviour. The data generated
from Google search volumes is being used to capture changing small investor emotions and
their effects on equities market performance in particular. A surprising shift in pessimism
among small investors, as assessed by the popularity of the most googled terms.

Commodities emergence as a distinct asset class:

Since they were first traded actively a decade ago, commodity markets have grown rapidly in terms
of volume and open interest. For far too long, people's primary investment options were equities
and debt. Commodities have arisen as an unique asset class in which individuals can engage through
the market mechanism since the introduction of commodity futures. The reasons for the emergence
of commodities as a distinct asset class are as below:

The benefit of leverage is the first large advantage with commodities futures. When we buy
commodities futures, we just have to pay a modest margin to open the trade. The margin is often
made up of a SPAN margin and an extreme loss margin. This is usually approximately 5-6 percent in
commodity futures, giving the trader a leverage of nearly 20 times. As a result, even with a little
margin investment, one can trade commodities.

The other advantage is that commodity futures are traded on an electronic market, with prices
decided by the forces of demand and supply in a transparent manner. Commodity traders know
exactly what price their order is executed at, and this transparency makes the entire process much
simpler and democratic.

Commodities are a wonderful way to protect against inflation. Commodities are typically included in
most inflation indices. The inflation index, for example, includes both agricultural and non-
agricultural components. Futures can be used to participate in the growth in price of these
commodities. As a result, it acts as an automated inflation hedge. In reality, among the major asset
types, commodities provide the best inflation protection.

Commodity futures can also be employed as a lead indication when making equities trading
decisions. Sterlite and copper prices, for example, tend to move in lockstep, with the commodity
price leading the stock price. Titan's price and gold's price have a similar link. Similarly, the price of
oil and the stock prices of companies like ONGC and Oil India have a favorable association.
Relationships like these can be leveraged.

Commodities: A Portfolio Diversifier's Catalyst

It's been a year since the terrible epidemic caught the globe off guard, and investors, both
professional and retail, may learn vital lessons. Despite the fact that the pandemic is akin to a black
swan event, investors should always build their portfolios such that unanticipated occurrences of
apocalyptic proportions have the least influence on their investments.

The good news is that investors do not need to use complex or quantitative technologies to
safeguard their holdings. In reality, because most quantitative instruments are designed to perform
under 'normal' situations, they will fail under the anomalous conditions that would be encountered
during the pandemic.

In a perfect world, investors would enhance profits while lowering risk. What makes you think this is
possible? By diversifying your holdings. When it comes to tradable assets, investors may invest in a
variety of asset classes such as stocks, bonds, and gold. Diversifying not just within a specific asset
class but also across asset classes is a key aspect of investing. It is not enough to have a diverse
portfolio of equities, such as an index fund, but it is also necessary to diversify across different
assets, such as fixed income and commodities. Commodities, according to commodity market
research, provide strong diversity in a stock and bond portfolio.

In a traditional portfolio optimization, high average returns and negative correlation to stocks and
bonds result in significant allocations to commodities.
Given the commodity futures index investment's historical risk-return profile – high average returns
and negative correlations to both stocks and bonds – it's maybe not unexpected that a traditional
portfolio optimization indicates a relatively high allocation to commodities within a portfolio.

Commodities perform well in severe markets, above and beyond the means and variances of
traditional portfolio optimization.
The traditional portfolio optimization exercise demonstrates that commodities' historical track
record of high average returns, high Sharpe ratios, and low to negative correlations with the major
asset classes makes a compelling case for including commodities in a well-balanced equities and
bond portfolio. However, it is well understood that the historical distribution of asset returns
frequently differs significantly from the assumed normal distribution in important ways, prompting
an investor to consider factors other than average returns, volatility, and correlations when
evaluating asset performance. For example, the historical distribution of returns for the
"conventional" 60/40 equity-bond portfolio reveals that "unlikely" occurrences occur more
frequently than predicted by the normal distribution. Furthermore, because extreme occurrences
are more likely to produce very low than extremely high returns, the distribution is said to be
"skewed" to the left in comparison to a normal distribution.

Commodities provide diversity in both equities and bond markets when it is most required.
Diversification is more than a question of correlation in a world where extreme occurrences are
regular; it's also a question of whether an asset can dependably minimise portfolio losses across a
range of market situations. It's a question of whether the asset will provide diversity when it's
needed the most, in markets where the 60/40 equity-bond portfolio's returns are at their lowest.
Because the same factors that produce "spikes" in commodity prices can also cause rapid falls in
equities prices, a commodities allocation is a natural buffer against poor performance of the 60/40
equity-bond portfolio due to real or predicted disruptions in commodity supplies.

Futures contracts for commodities and the future of commodities investment

"Enhanced" index techniques have been a popular tool for investing in commodities as an asset class
in recent years. While the classic broad-based commodity index remains the most popular
benchmark for investing in commodities as an asset class, "enhanced" index techniques have
emerged in recent years as a viable option for commodity investments. Enhanced Index Strategies,
in general, are rules-based strategies that aim to beat benchmark commodity indices by modifying
index rules. Market concerns regarding negative carry in commodities index returns owing to
contango in futures curves that accompanied the rise in physical prices to higher sustainable levels,
primarily in the energy markets, prompted the birth and fast dissemination of Enhanced Index
Strategies in recent years.

However, some of the new products that have arisen might be called a new generation of
commodities investment products, with some of them appearing to be superior to classic benchmark
Indices in terms of risk, return, and diversity. Simple changes in index rules were the first moves
toward market upgrades, with the goal of avoiding the Benchmark Indices' "footprint." These
changes included moving outside of the 5th to 9th business day of the month frame established by
the two main commodities indexes, the S&P GSCITM and the DJ AIG, or continuously staying one or
two contracts ahead of the Benchmark Indices' usually front month futures contracts. However, as
the market has evolved toward this sort of strategy, any "alpha" generated from these types of
technical methods has soon eroded, with the index roll basically becoming a monthly event. It's
unclear that a strategy aimed at avoiding the index footprint will produce meaningful long-term
outperformance.

Some of the other index upgrades that have been produced in the market, on the other hand,
deliver outperformance based on basic commodities market trends that are more likely to continue
over time. Some solutions, for example, alter index rules for commodities with strong seasonal
trends, such as natural gas, heating oil, and some agricultural and livestock commodities. These
seasonal strategies aim to outperform the Benchmark Indices by rolling futures contracts for
commodities with consistent seasonality in those times of the year when the futures curves are
more likely to be backwardated due to higher market uncertainty, such as winter for Natural Gas or
planting season for grains, as well as avoiding rolling in those times of the year when the futures
curves are more likely to be backwardated due to historical contango in the market, such as summer
for equities.
In a macro sense, these fundamentals-based enhancements provide a more customised way for
passive investors to provide risk capital to the marketplace, selling insurance to producers during
times when insurance is more expensive and avoiding times when financial investors are effectively
buying insurance. Dynamic rolls is another adaptation that has been created for Crude Oil, which is a
substantial component of commodities indexes but does not display seasonality patterns. When the
front end of the curve is in contango, Dynamic Strategies roll crude oil futures contracts dynamically,
shifting from the standard front month roll to a roll further out the curve only when the front end of
the curve is in contango, minimising the negative carry that can be most pronounced. At other times,
the Dynamic Strategies are a carbon copy of the standard roll, profiting from the backwardation in
the curves and the positive returns that occur.

In a nutshell, outperformance from this technique occurs when the market has negative carry,
allowing financial investors to escape negative return headwinds during those periods. Investors
making strategic allocations to commodities as an asset class, as well as those expressing tactical
views in broad indexes or sub-indices on individual commodities, have turned to Enhanced Beta
strategies, which integrate the different changes outlined above. Separately, the historical returns
achieved by going long this sort of Enhanced Index Strategy and short the equivalent Benchmark
Index have attracted investors looking for non-correlated sources of returns. We expect the creation
of new financial solutions for investing in commodities as an asset class to continue as investment
flows to commodities increase.

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