Retail investors unlikely to gain from investing in commodity funds
Although 2014 turned out to be a bumper year for equity investments, one cannot say the same for commodity funds. In the last one year, these funds have delivered returns in the range of -24% to 5%. Indian investors can invest in commodity funds via feeder funds. Indian asset management companies (AMCs) invest their corpus into global mutual funds which invest in commodity-related securities. They do not trade directly in commodities like gold or iron ore but do benefit from global diversification properties of commodity funds. It is important to remember that the performance of commodity companies is prone to factors and sentiments driving equity markets in general, which may not always play out favourably from an investor's perspective. For instance, in 2011, gold, thermal coal, copper, aluminium and iron ore rose 20-30% on a year-on-year basis, but stocks of companies dealing in these commodities remained beaten down due to global macroeconomic uncertainty.
WHAT WENT WRONG FOR GOLD?
Gold bullion displays an inverse relationship with the US$, which was seen during 2014, according to Pankaj Sharma, EVP and head, business development & risk management, DSP Black Rock Investment Managers. "The strong US dollar, helped by US economic strength and hawkish US Fed interest rate guidance, rose during the second half and it was reported that US GDP grew at an annualised rate of 4% in the second quarter of 2014, 1% above the average predicted by economists," he adds. Also, lacklustre physical demand and alleviation of political tensions later in the year acted as headwinds for gold.
OUTLOOK FOR GOLD FUNDS
According to Sharma, physical demand from emerging economies such as China and India will continue to support demand for gold. On the supply side, projects and exploration budgets have been shelved, which may provide an opportunity for the gold price to trend steadily higher over the coming years. Although the backdrop of US$ strength has historically been a challenging one for precious metals and the experience of 2014 to date has been no different, there are still some significant risks to markets that gold has been used to hedge against, most notably shocks to the financial system and inflation. The most relevant way to think about gold is not in isolation but as part of a well-diversified portfolio. It can help investors preserve wealth and reduce risk.
AGRI COMMODITIES FARE BETTER THAN GOLD
The key challenge for the agriculture sector in 2014 had been the weak price performance of its main crops. "The continuation of favourable weather conditions and larger-than-expected stocks have led to expectations of a bumper harvest, resulting in lower farm incomes," says Sharma. However, some areas have benefitted from this market environment. In fact, funds focusing on agricultural companies have posted positive to flattish returns. Looking ahead, Sharma expects prices of the main crops to remain subdued. However, it is unlikely that crop prices will weaken to the extent that they have in 2014 as they approach the cost of production. According to Varun Goel, head PMS, Karvy, commodities, be it precious or industrial metals, have followed a 10-year cycle since 1920. "While 2002-12 was a great time for commodities, 2012 onwards prices began sliding and we are unlikely to see any fireworks from this segment," he says.
MINING FUNDS ARE CYCLICAL
Sharma believes the primary driver of metals is a supply/demand imbalance where the potential for future deficits have provided support and potential surpluses have weighed on prices. Despite positive fundamentals for a number of metals, the mining sector began to retreat in late August and has continued this downward trend since. The reasons were reports of soft Chinese economic data and anaemic data from Europe. "With China contributing 40-45% of demand, the slowdown will impact base metal prices," says Naveen Mathur, associate director, commodities and currencies, Angel Commodity Broking.
The cyclical nature of mining funds is evident in the case of Birla Sun Life (earlier ING Optimix) Global commodities fund, which delivered a whopping 71% during November 2008 to November 2009, during the hype on global commodities. The same fund has delivered a negative 15% return in the past one year. Other mining-based funds have also followed suit.
Having said that, Sharma believes that the industry has made good progress in refocusing its strategy; operating costs have been aggressively targeted and investments in projects reassessed. "We are entering a seasonally stronger period for mining demand, which in the past has supported commodity prices; industrial activity typically picks up in the fourth quarter, following the summer lull," he adds.
Energy funds like DSP BlackRock Energy Fund had to face the key challenge of oil prices dropping about 35% between June and December 2014. According to Sharma, the recent fall is on the back of weak demand growth, particularly from Europe and Asia, reduced supply and continued production growth from the US. When prices fall, oil and gas companies generate less money. In fact, oil and gas groups make up 15% of the FTSE 100 index, so whether you invest via a 'tracker' fund or an active fund manager, the oil price fall will have hit your investment returns.
The energy sector remains an underweight for many investors and still trades at a significant discount to the broad equity market on both price-to-book and price-to-earnings multiples. "Further, the action by central banks to prop up their economies may create incremental demand. We see prices at $84 per barrel in the next one year," says Mathur of Angel Broking.
SHOULD YOU INVEST?
According to Goel of Karvy, the commodity story is over for now. Investors must exit these funds and seek more lucrative options for the same amount of risk. Commodities are generally seen as a bull market phenomenon. There is still a big question over the influence of China on prices due to the support it lent for years. As China moves away from infrastructure development and towards consumer spending, demand for commodities is likely to be structurally slower. Except gold, which provides a safe haven and diversification, commodities are not a necessity in any investment portfolio. However, a commodities fund can add punch to a portfolio during a structural uptrend.
