Investor interest in commodities has increased dramatically in recent years as the asset class has outperformed traditional assets such as stocks and bonds.
The performance of commodities as an asset class is usually measured by the returns on a commodity index, such as the Dow Jones-AIG Commodity Index, which tracks the return from a passive investment in 19 different commodity futures contracts.
Over a five year period ended March 31, 2006, the Dow Jones AIG Commodity Index has returned 10.6%, versus 2.6% for the S&P 500.
Commodity prices have been driven higher by a number of factors, including increased demand from China, India and other emerging countries that need oil, steel and other commodities to support manufacturing and infrastructure development.
The commodity supply chain has also suffered from a lack of investment, creating bottlenecks and adding an insurance premium and/or a convenience yield to the returns of many commodity futures. Over the long term, these economic factors are likely to support continued gains in commodity index returns.
The potential for attractive returns is probably the most obvious reason for increased investor interest in commodities, but it isn't the only factor. Commodities may offer investors other significant benefits, including enhanced portfolio diversification and a hedge against inflation and event risk.
Commodities are real assets, unlike stocks and bonds, which are financial assets. Commodities, therefore, tend to react to changing economic fundamentals in different ways than traditional financial assets. For example, commodities are one of the few asset classes that tend to benefit from rising inflation.
As demand for goods and services increases, the price of those goods and services usually goes up as well, as do the prices of the commodities used to produce those goods and services. Because commodity prices usually rise when inflation is accelerating, investing in commodities may provide portfolios with a hedge against inflation.
Leverage is very important to the commodities markets. Unlike the stock market, where you might have to invest 10,000 dollars to leverage 10,000 dollars. A commodities trader can leverage tens of thousands of dollars worth of a commodity for pennies on the dollar. Also unlike stocks, commodities have intrinsic value and will not go bankrupt.
Commodities also give the investor the ability to participate in virtually all sectors of the world economy and have the potential to produce returns that tend to be independent of other markets.
In fact portfolios that add commodity investments can actually lower the overall portfolio risk by diversification.
