Index stays on track
Commodity indices are less volatile than the prices of resource stock, writes Barbara Drury.
Commodity indices are less volatile than the prices of resource stock, writes Barbara Drury. China's rapid economic development combined with a post-global financial crisis lack of confidence in the US dollar, shares and bonds has fuelled a boom in tangible assets that hurt when you drop them on your foot. Gold bars, barrels of oil, iron ore and bales of wool are in hot demand, prompting a rash of new investments to cash in on the trend.The latest is a suite of five commodities-based exchange-traded certificates, or ETCs, which give investors access to 36 globally traded commodities ranging from wheat and livestock to industrial and precious metals, gas and oil (see box).The new ETCs offered by the Royal Bank of Scotland are based on the Rogers International Commodity Index (RICI) developed by the legendary investor, Jim Rogers, more than a decade ago.At the launch of the RICI ETCs last month, Rogers argued that a secular bull market for commodities began about 12 years ago and still has years to run. (A secular bull market is a long-term up-trend that might have short-term falls or pauses.)Another investment veteran, GMO's Jeremy Grantham, made headlines this year when he warned that the rising global population, Asia's demand for raw materials and a finite supply of resources would lead not just to a peak in oil reserves but to "peak everything".He argued that this was reflected in a paradigm shift in commodity prices in 2002 (see graph), which marked the start of a long-term commodities boom.Not everyone is convinced, however. An investor and the author of the Sound Money. Sound Investments newsletter, Greg Canavan, says commodity prices can be driven by liquidity. For example, when the US was injecting cash into the economy through its so-called quantitative easing strategy, commodities were a good way to tap into the increased liquidity."Since QE11 ended [in June], commodity markets have been doing it tough because a lot of speculative behaviour is out of the market," Canavan says. But Rogers argues the outlook for commodities is positive whatever happens to the global economy.If growth picks up then demand for raw materials will also pick up but if the world slides into recession, he says, it is still good to be in commodities because governments will print money to prop up their economies. "I think the best asset, probably for the rest of the decade, is commodities," he says.Until now, local investors seeking exposure to commodities have been limited to shares in resources companies, exchange-traded funds that specialise in gold, silver and other precious metals, or one of a handful of managed commodity funds.The new ETCs are aimed at private investors who want exposure to commodity prices without the additional risks involved in resources stocks. The vice-president of structured products for the Royal Bank of Scotland, Tania Smyth, gives the example of someone who wants to invest in agricultural commodities. If they bought shares in a company affected by the Queensland floods their shares might have been hammered, even though agricultural commodity prices continued to rise because of a shortage of supply."Investors get exposure to the commodity price, not the company," Smyth says.Commodity indices tend to be less volatile than the prices of resource stocks. Prices for individual commodities can be extremely volatile in the short-term but investing in a diversified index can smooth returns.The chief economist at CommSec, Craig James, points out that despite the turmoil on commodity markets, the CRB commodity futures index is up 0.4 per cent since the start of the year. But this hides a multitude of sins.While wool and gold are standout performers, both up 28 per cent, rice is up 14 per cent and iron ore up 6 per cent, cotton is down 27 per cent, nickel is down 13 per cent, zinc and copper 10 per cent and wheat 11 per cent."If you have a broad belief in the Asia growth story then embrace commodities," James says.How the low-cost derivatives workThe Royal Bank of Scotland's (RBS) five commodity-based exchange-traded certificates (ETCs), based on the RICI Enhanced agriculture, metals, energy, agriculture ex-livestock and global indices, are set to commence trading on the ASX tomorrow.ETCs are low-cost index investments that can be bought and sold on the ASX like exchange traded funds (ETFs). But unlike ETFs, ETCs do not hold physical assets.The RICI Enhanced indices are actively managed by commodities expert Jim Rogers and underpinned by commodity futures contracts.In other words, investors are buying a derivative product, not real barrels of oil or sacks of wheat.The RBS buys futures contracts to hedge the portfolio. Because commodities are priced in US dollars, the investments are currency hedged so local investors get the full performance of the index price.The products have an annual management fee of 0.89 per cent, which is more expensive than some ETFs but cheaper than comparable managed funds.Although they are simple to buy and sell, their construction is complex so investors should read the product disclosure statement on the RBS website.They are a first for the local market but Smyth says similar ETCs have been available in Europe for more than five years and have $2 billion in assets under management.