Commodities - Investors Academy

Investing in commodities?

Commodities are natural resources that are grown or extracted worldwide. They play a role in all production processes and therefore form the backbone of the global economy. Consumers and manufacturers find each other on the commodities market, on which they buy and sell.

The market mechanism and therefore commodity prices are driven by supply and demand (and the associated uncertainties). Each commodity has its own clearly-defined market. For instance, supply and demand are very different for wheat and crude oil, which means that the correlation between the various commodities is generally low. Due to this important role and the specific characteristics of the commodity markets, commodities are an investment category that can add real value to your securities portfolio.

Advantages of investing in commodities?

Investing in commodities also ensures diversification within the investment portfolio as a whole, given that the correlation with other investment categories such as shares and bonds is also generally low, with the exception of specific shares related to commodities.

On the other hand, they are characterised by high volatility, but are not very sensitive to inflation. In other words, they retain their value.

ABN AMRO uses four types of commodities: energy (f.e. crude oil), base metals (f.e. copper), precious metals (f.e. gold) and agricultural (f.e. wheat). Investing in commodities can be done in different ways: physically, via futures (forward contracts) or indirectly. All commodities share the fact that no interest or dividends are paid out. All changes in the value of a commodity position arise from the price evolution of the underlying commodities (as well as fluctuations in the exchange rate). The most appropriate solution for private investors is, for example, to invest indirectly in commodities by purchasing an ETF (tracker) or an investment fund that invests in commodity futures.

General characteristics of indirect investments in commodities

Standardisation:
Commodities are traded in standard quantities at a predetermined quality (not always possible).
Maturity:
No fixed maturity.
Futures contracts:
Forward contracts, or futures contracts, in commodities are contracts in which it has been agreed in advance how much of a specific commodity you will receive or when you will receive the commodity. Such contracts exist per commodity and have various maturities. You can buy and sell these contracts on the futures market.
Backwardation and contango:
Futures contracts expire at various times. The expiry date is the date on which you receive or must deliver the commodities. Futures contracts with different expiry dates may have different prices. If the price for a futures contract which expires sooner is lower than that of a futures contract with a longer maturity date, we call this contango. This is caused by storage costs, insurance and financing costs and the uncertainty concerning the supply of these commodities in the future. If the price of a futures contract which expires sooner exceeds the price of a futures contract with a later maturity date, we call this backwardation. This is the opposite of contango. This may occur, for example, due to a shortage of that commodity, significant demand from companies to acquire the commodity immediately, or because many investors believe that there will be less demand for or no shortage of the commodity in the future.
Roll-over:
You can avoid having to acquire or deliver the commodities by selling your futures contract. This is done by entering into a new futures contract with a later maturity date for the same commodity, meaning that you sell the contract that is about to reach maturity and immediately buy a new one that runs longer, otherwise known as a roll-over. With backwardation, the new contract will be cheaper. With contango, it will be more expensive.

Investing in gold or precious metals

Precious metals are pure metal elements. They are used in aviation and space travel, medical technology and mobile telephones and laptops, for example. If you wish to invest in precious metals, you can invest in gold, silver and platinum. The actual value depends on the price and exchange rate at which the precious metal is listed. When the economy is weaker or (geo)political risks become more significant, investors often resort to gold as a so-called 'safe haven'.

There are four ways to invest in gold:

Buy gold bars or gold coins. The gold is kept in a safe at a financial institution. Within ABN AMRO Private Banking Belgium, however, we do not offer this solution.
Buy shares of a gold investment fund. You invest indirectly in gold, so nothing has to be kept in a safe.
Buy shares in gold mines. These usually track the price of gold, but can also be very volatile.
Buy derived products (ETC). The ETC buys physical gold and stores it for you in safes; this gold serves as collateral for your investment. You then participate equally in the evolution of gold.

General characteristics for gold or precious metals

Protection against inflation:
Gold offers protection against inflation (in the long term, gold would retain its value in real terms).
Correlation:
Gold is a non-correlated asset. The price of gold does not evolve as the value of traditional asset classes (shares, bonds), whereby it can occupy a position in a well-diversified portfolio.

Indirect investment in commodities: the risks

Below we have briefly summarized the main risks of indirectly investing in real estate:

Liquidity risk:
For some commodities, the market is not huge and the volumes traded are low. This implies an increased liquidity risk.
Volatility risk:
The return on commodities (including gold) is generally highly volatile and depends on a wide range of factors, such as global demand for a given commodity, the global economic climate, geopolitical problems and so on. These factors can have a strong influence on prices.
Market risk:
If you do not invest directly in commodities but use futures instead, the underlying asset is difficult to predict.
Counterparty risk:
As an indirect investment in commodities sometimes uses derivatives, the counterparty may not be able to meet its obligation.
Exchange rate risk:
The price of commodities (including the price of gold) is usually fixed in US dollars on global markets. For European investors, fluctuations in the dollar therefore affect the value of their positions.

Costs and taxes

Tax on stock exchange transactions:
Tax that applies to commodities on the secondary market. The stock exchange tax depends on the type of product you buy or sell.
Brokerage fee:
The cost of executing your orders on the secondary market.
Custody fee:
The cost of holding your share in a securities account.
Withholding tax on dividends:
Only applicable to ETCs that pay dividends. You are required to pay withholding tax on your dividends received in Belgium. For dividends from ETCs of foreign companies, you will first be taxed in the country of origin and then in Belgium. A part of this can be claimed from countries with which Belgium has concluded a tax treaty.