Long-term bets can still pay off in commodity funds, say analysts

Moderate your return expectations after the 18-month bull run

Consumer price index (CPI)-based inflation rose to 6.07 per cent in February, up from 6.01 per cent the previous month. High inflation is beginning to pinch household budgets. One way investors can hedge its impact on their finances is by investing in commodity funds.

Chinese pivot reduced supplies

Commodity funds have delivered an average return of 23.9 per cent over the past year and 15.2 per cent annualised over the past three years. Several factors contributed to this performance.

Commodity companies’ realisations have increased steeply over the past 18 months. Says Rohit Singhania, co-head of equities, DSP Investment Managers: “This led to an increase in profitability and high cash flow generation. This, combined with capital discipline, led to deleveraging of their balance sheets. The debt proportion of enterprise value (EV) came down and the equity portion went up in the mix.”

The Chinese government’s policies aimed at curbing pollution, too, have played a part. Says Lalit Kumar, fund manager, ICICI Prudential Mutual Fund: “China’s control on domestic production due to decarbonisation and restriction on export also helped metal stocks.”

The price of crude oil has increased from negative levels in April 2020 to over $100 a barrel currently, aiding the performance of commodity funds. “The exposure to upstream companies and offshore funds (BGF World Energy Fund) benefitted from this as they saw multi-fold increase in profitability,” says Singhania.

Outlook remains positive

Fund managers feel commodity funds may yield more moderate returns in the future, but are likely to do reasonably well over the medium term.

With capacity addition likely to be low, commodity prices could remain elevated. “With many countries, including China, focusing on decarbonisation, capacity control by the Chinese government, and limited investment in commodities in the past four-five years, commodity funds offer a good opportunity from the medium to long-term perspective,” says Kumar.

In the oil space, profits seem to be shifting towards upstream companies. “Valuations relative to the market are still lower than past averages, which makes it an attractive space,” says Singhania. Oil marketing companies’ performance, according to him, will depend on how marketing margins play out in the next few quarters. A couple of other factors will also determine whether this bull-run continues. “It will depend on whether the level of economic activity and systemic liquidity remain high globally,” says Vaibhav Porwal, co-founder, dezerv., a wealth-tech firm.

Cyclical, volatile asset class

High volatility is an intrinsic feature of this asset class. “When demand increases, supply follows. But in the later stages of this positive cycle, oversupply can lead to a price crash,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

Commodity producers have high fixed costs and relatively lower variable costs. “When prices rise, margins increase disproportionately. But when prices fall, margins are also hit disproportionately,” adds Dhawan.

Regulatory interventions can also affect prices. “In the steel industry, for instance, there have been many instances of the government hiking custom duties to curb imports,” says Porwal.

As green energy sources gain ground, producers of traditional energy could be adversely affected.

What should you do?

Don’t place short-term bets on commodity funds just because their prices have risen in the recent past. Trying to time your entry and exit from these funds could prove futile.

If you wish to make a long-term, strategic allocation, you may still enter them. Invest with at least a seven-year horizon. Even if these funds tank in the medium term, you will earn a decent return if you stay invested through one down and one upcycle.

When commodity prices fall, the assets under management (AUM) of these funds tend to shrink. Avoid rushing to the exit at such times.

To mitigate risks further, invest gradually via the systematic investment plan (SIP) route and limit exposure to 10 per cent of your portfolio.