18.5 Commodities as alternative asset

Definition of an asset class

A commonly used approach is to consider as an asset class any instrument:

1. That generates returns that are higher than risk-free returns,
2. Whose returns demonstrate little or no correlation with other asset classes,
3. Whose returns may not be replicated with a simple linear combination of other assets.

Commodities are becoming critical for fuelling India’s economic growth. Investment in commodities not only has a balancing effect on the portfolio, but also acts as a natural hedge. Commodities can be considered a separate strategic asset class as they have demonstrated positive returns, have a very low correlation with existing asset classes and their returns cannot be replicated with existing asset classes.

These returns can also be captured at a very low price (management fees and administrative/controlling costs)in comparison to other alternative assets as most such mandates are managed on a passive basis. In addition, commodities are more liquid than most other alternative asset classes.

The sharp rise in commodity – especially crude oil – prices since 2001 has led many investors to place a growing share of their assets in commodities. The vehicles used by investors to gain exposure to commodities are commodity futures contracts and funds benchmarked to commodity indices based on various underlying commodity futures.

Empirical evidence shows that commodities as an asset class facilitates portfolio diversification. Low/negative correlation allows commodities to reduce overall portfolio risk.

Commodities act as a hedge against inflation

Equities and bonds display poor hedge against inflation. In fact they tend to perform at their worst during periods of high and rising inflation. Empirical evidence shows that commodities perform at their best in these periods. Commodity prices tend to be positively correlated with inflation.