Commodity Fund as Alternative Investment - Literature review Example

Name: Lecturer: Unit Name Date of Submission: Alternative Investment: Commodity Fund The commodity fund involves the use of primary economic sector products. The products are categorized into two soft and hard commodities. The soft commodities include cocoa, sugar, wheat and coffee while hard commodities include oil and gold. The first commodity futures indexes (Goldman Sachs Commodity Index) was introduced in 1991 and later changed to S&P GSCI. The index was designed to gather for the investable products (Nazlioglu et al., 2013). The DJ-AIG Commodity Index was later introduced in 1998. The commodities were then introduced in the exchange-traded funds in 2004, and as per 2012, commodity related ETFs were more than 197. Currently, an SPDR Gold share holds a greater proportion compared to other commodities traded in ETFs. Therefore, it is clear that the popularity of the commodity trading has grown. Though, there are controversies on either to classify commodity fund has a class of assets or alternative investment. The articles are proposing that the commodities are a class of asset put forth that they show the same risk and return characteristics and the different means of benchmarking i.e. using underlying instruments such as futures contracts (Nazlioglu et al., 2013). Kaplan argues out that commodities do not have market capitalization since the long position offsets each short position. Also, he adds that the commodity does not have a beta which is a measure of the market volatility. Therefore, he differs from the idea that commodity is an alternative investment. Those for alternative investment cite various characteristics exhibited by the commodity-related funds. First, the alternative investments are considered illiquid compared to a class of assets. Therefore, the investor who invests directly in and holds physical commodities restricts the liquidity of the investment. For example, an investor holding a bar of gold cannot easily convert it into cash. Secondly, the rising popularity of trading commodities in futures contracts and ETFs as noted by Morningstar (2012) gives it an alternative investment meaning. Through futures contract and ETFs, an investor can take both long and short position in the commodities market. The investor does not have to take both positions to be considered an alternative investment. Lastly, the increased number of players in the market has called for increased standardization and thus changing the meaning from a class of assets to an alternative investment. Also, increasing sophistication of commodity fund changes its meaning. The Morningstar (2012) provides evidence on a survey they conducted to find out if the commodity is an alternative investment. The survey shows that 78% of the respondent considered it an alternative investment. The investment institutions believe that alternative investment gain access to commodities through tracking of ETFs. Therefore, the commodity fund meets the characteristics of an alternative investment. Additionally, the survey found out that 25%of the investors held both long and short position strategy but a small proportion holds the physical commodities. The institutions that did not hold the view of alternative investment considered it a core allocation. According to the analysis above, we can note that those who hold that the commodity fund is alternative investment have stronger supporting evidence than those who view it as a class of assets. The major points noted include the fact that direct investment is illiquid since the investor cannot easily convert the commodity into cash. Second, the investor can take both long and short position in the market. Thirdly, the number of investors in the commodity market has been on the rise and thus subjected to constant improvement of the fund. The increased sophistication regarding standardization improves it more of an alternative investment than a class of assets. Lastly, the commodity fund does not take the form of traditional investment, and thus the closest classification is an alternative investment (Mensi, Walid, et al., 2013). The use of a commodity as an alternative investment has some merits which are in line with other instruments such as REITs, hedge funds, and private equity. These merits include; the investment on commodity fund provides the potential of high return compared to other forms of investment. The morning (2012), the trade volume increased from $2.1 billion in 2003 to $150.4 billion in 2011. The growth signifies that the financial instrument provides attractive returns and gaining popularity in the financial market. The commodity prices are affected by the changes in factors affecting supply and demand such as inflation, the health of economy and exchange rate (Acharya et al., 2013). Therefore, the rise in the return in the recent past is associated with increased global infrastructure that has influenced prices. The value of commodity instruments has a positive correlation with changes in prices of goods and services and thus increase in inflation increases the value. The correlation with general prices of goods and services brings the subject of cautioning investors from inflation. The commodities have shown resilience compared to other instruments such as stocks and bonds (Acharya et al., 2013). The performance of commodities increased during the period of high inflation. The investors should note that commodity instruments are volatile sometimes for example oil has fluctuated in the recent past due to changes in the global market of oil. The commodities improve the diversification of investor’s portfolio since the investment on commodity fund has a negative correlation with other types of investment such as stocks and bonds (Acharya et al., 2013). The market volatility is reduced by the lockstep nature of the investments. The diversification reduces risk exposure but does not guarantee profit or loss. The use of commodities as a vehicle of alternative investment subjects investor to some risks. The risks include; the principal/major risk arises from the general volatility of the commodity market (Fidelity). The prices fluctuate due to changes in the global economy and other events such as elections, imports, government regulation and political stability. For instance, the political instability in the Middle East has greatly affected the prices of oil in the commodity market. Therefore, an investor should have a wider perspective in the analysis the most viable commodity before making an investment decision. The higher than average volatility risk is evident when tracked using exchange-traded products (ETPs) or Mutual funds of the commodity. The use of futures, swaps or other derivatives instrument to hedge against the risk shows greater volatility than investment without hedging due to speculation in the derivative market. The commodity instrument is also exposed to foreign and emerging market risk (Sockin et al., 2015). The risks are associated with changes in the foreign exchange rate, political stability, economic environment, globalization and integration (Brexit). The commodity fund has been considered to diversify investors’ portfolio but assets are concentrated and thus not diversified by themselves like other funds such as REITs (Sockin et al., 2015). For example, REITs have a mixture of investments, but commodities are concentrated in one or two industries for example minerals such as gold and oil. Therefore, a slight change in market value of an investment causes a huge fluctuation in the share price and result in huge losses. Therefore, it is recommended for an investor to hold other alternative investment such REITs and hedge funds to improve their portfolio diversification. The commodity stock fund usually uses derivatives such as futures contract to trace an underlying commodity or index. Therefore, the trading of such securities depends majorly on speculation and tends to move with the demand for the stock. The performance of the commodity fund hugely differs with the performance of the underlying commodity and thus depending on market condition and fund’s investment strategy, the performance would lead to profit or loss. Therefore, the profits or loss are not predictable and depend on some factors. The take home points on commodity fund are that it adjusts with the inflation and thus hedges the investor from loss of value of money compared to another instrument. The commodity market is highly regulated, and gold is even used by IMF and most countries to back the currency hence stable. Additionally, it is important to invest in commodity stock fund with other alternative investment instruments to improve on portfolio diversification since holding the only commodity in the portfolio is not enough since the assets are concentrated in few industries. Also, the readings provided an incite why government and IMF use gold commodity in backing the currency since they are stable and have a positive correlation with general prices in the economy. Additionally, I was able to learn about underlying assets (derivatives) and that it does not have market capitalization since the short position is offset by long position. Lastly, the commodity funds are affected by currency movement, economic environment, government regulation and political stability and thus important to thoroughly analyze these factors before deciding on investment plan (Sockin et al., 2015). The discussion on either to classify commodities as an alternative investment or just a class of assets confuses me a lot. Though many articles have cited it as an alternative investment, I still need lecturer’s clarification to decisively settle on it as alternative investment or class of asset. Reference: Acharya, Viral V., Lars A. Lochstoer, and Tarun Ramadorai. "Limits to arbitrage and hedging: Evidence from commodity markets." Journal of Financial Economics 109.2 (2013): 441-465. Creti, Anna, Marc Joëts, and Valérie Mignon. "On the links between stock and commodity markets' volatility." Energy Economics 37 (2013): 16-28. Fidelity. "Commodity Investing - Fidelity". Fidelity.com. Web. 22 Apr. 2017. Mensi, Walid, et al. "Correlations and volatility spillovers across commodity and stock markets: Linking energies, food, and gold." Economic Modelling 32 (2013): 15-22. Nadia Papagiannis, “Commodities: Just another Asset Class, or Alternative Investments?” Morningstar (2012): 2-4 Nazlioglu, Saban, Cumhur Erdem, and Ugur Soytas. "Volatility spillover between oil and agricultural commodity markets." Energy Economics 36 (2013): 658-665. Sockin, Michael, and Wei Xiong. "Informational frictions and commodity markets." The Journal of Finance 70.5 (2015): 2063-2098. Read More