Commodities Investing Hedging Your Consumption- Part III

RUBIK CAPITAL PARTNERS January 22, 2013 Authored by: Kaushal Shah

Commodities Investing
Hedging Your Consumption- Part III Recap In the previous two articles in the Commodities Investing series (you can click here to download a copy of both articles), we reviewed the basic philosophy behind investment, namely protecting investors from the inflation should be the first priority of any investment. We also introduce the concept of inflation and CPI, and how CPI is measured based on various household expenditures. Really the building block of any inflationary phenomenon is commodities, either through raw materials or processed product. In second article of the series, we also demonstrated that commodity investing would have been very profitable investment in last decade and thus not only would have protected investors from inflation but also would have outperformed almost all other asset classes. In this article, we will take one step further about how to invest into commodities. This is especially important, when everyone has heard some story of a person speculating into commodities markets (either a good or bad story). And, thus all individual investors think (wrongfully) that one has to be a trader or speculator in order to invest in Commodities. Of course that is not truth (true?) and that is why we are writing this article. Unavailability of Commodity Investment Vehicles Investors usually use various investment vehicles like Fixed Deposits, RBI Bonds, Mutual Funds or ETFs (for sophisticated investors) for their investment needs in equities (stocks) or bonds. However, investors usually do not invest into Futures and Options contracts on a regular basis.
Commodities Investing | 1/22/2013

While, ETFs and Mutual Funds are well-developed instruments for investing in commodities like Gold and Silver, those instruments are not available for other commodities, i.e. Oil, Agriculture, Minerals. One reason is the ease of storage for Gold and Silver compared to other commodities. Literally, the ETFs and Mutual Funds companies designate a piece of Gold (based upon your investment size) onto your name and store it in safe-lockers. Of course, the same cannot be said for Oil or Agriculture, as either they are too large in volume to be stored efficiently or they are perishable commodities.

Due to these reasons, usually investors do not have direct exposure into commodities and thus stay on sidelines from investing in commodities. Futures Contracts Before we jump into the solutions to invest in Commodities, we would like to introduce Futures contracts in brief. Futures contracts are called derivatives and are traded on exchanges. Futures are contract made between two individual investors/traders where one promises to buy a particular commodity at specified later date at specified price and the other investor/trader promises to sell. Futures contract refer to the spot price of the commodity. Leverage Many investors relate futures contract to leverage automatically and consider investing in Futures contracts as speculation and risky investments. But, nothing could be further from the truth. Futures contract doesnt require investors to put all the money, rather investors just need to put partial portion, known as Margin. The figure 1 shows difference between how much investment is required and how much exposure investor can get in Stocks and Futures. As you can see, stocks usually requires investment of 100 INR in order to get exposed to 100 INR, whereas only 10 INR apporx. in futures can get you similar exposure. This is why investors CAN (does not necessarily have to) leverage their investments using Futures.

1. Investment & Leverage

120 100 80 60 40 20 0 120 100 80 40 20 0 60

2. Futures - No Leverage

Investment Stocks

Exposure Futures Contract

Investment

Exposure

Futures Contract

Government Bonds

Solution Despite of unavailability of Mutual Funds and ETFs, the futures markets are very liquid into commodities markets. Thus, investor can always invest into Commodity futures contract to

Commodities Investing | 1/22/2013

gain exposure to commodities. However, futures contract are of maturity one-to-three months and thus contract should be rolled over (i.e. Selling on Expiration and Buying the New contract) every month or so. Due to this layer of complexity and active involvement, it is advisable to let investment professionals handle your investment into commodities. Besides the complexity, the size of the future contract is one more reason for the need of the investment professionals. Each contract has high notional value of about 2-3 lac INR that limits investors to invest in diversified portfolio of several commodities (lower risk). Investment professionals can pool their clients money to optimally diversify the commodity investments. Rubik Capital Partners Strategy & Offerings We deploy non-leveraged strategy to invest in Commodities. What we mean is summarized in Chart 2 on a previous page. Instead of taking 10 times exposure (and Risk), we divide 100 INR into two parts 10 INR and 90 INR. We use 10 INR to get exposure to 100 INR using Futures contract, but we invest 90 INR into safe RBI Bonds and thus we do not use leverage. At Rubik Capital Partners, we offer comprehensive asset allocation portfolio investments for our clients, where we also run dynamically managed investment strategy investing commodities using futures. Thus, investors need not have to worry about preserving their purchasing power against inflation or rolling their futures contracts into new monthly contracts.

Commodities Investing | 1/22/2013