Editor: Nadeem Mian
In the world of Islamic investing and portfolio management, where assets such as fixed income (i.e. traditional bonds) and leverage are prohibited, there tends to be more of an interest in alternative classes such as commodities to help fill that void.
This missive will highlight some of the pros and cons of adding commodities to your portfolio but before diving into that it’s important to understand what they are and what form/vehicle is used to get exposure to that commodity. Also, the article will mostly speak to sharia compliant forms of commodity investing.
What are Commodities:
Commodities include assets such as oil, gold, metals and agricultural products. Each commodity is priced differently and has different price drivers. For the most part these underlying assets are typically halal themselves unless of course we’re talking about a product dealing in pork.
Typically there are 2 primary ways in which an investor can gain exposure to commodities.
The most common and oldest way to invest:
- Direct: The oldest way to invest in a commodity would be to purchase the physical commodity itself; so example an investor can choose to purchase and possess gold coins or bars. However the issue with physical assets is that typically they have higher transaction and storage costs and not every commodity makes sense to own physically (i.e. owning a barrel of crude oil). The most common method today is by purchasing derivative securities such as future contracts of the underlying commodity asset. They have much lower transaction costs and no storage fees (compared to physical assets). On the other hand, derivatives involve the use of leverage and therefore are not sharia compliant. The newest form of direct investing in commodities is through exchange traded funds (ETFs) that are invested and holding derivative contracts and/or the physical asset. They tend to have lower transaction and storage fees than physical asset but slightly higher than derivative contracts. However, not all commodity based ETF’s are sharia compliant as a majority of them use derivative contracts. Only ETF’s that invest and possess the physical underlying commodity asset would be considered sharia compliant. Please contact one of our ShariaPortfolio Financial Advisors for more details.
- Indirect: This would include the purchase of stocks issued by firms that produce the underlying commodity. So an investor bullish on oil may purchase the shares of an oil company. However, this may not be an ideal way to gain exposure to the underlying commodity, since company risk and other non-commodity related factors play into the price of the stock. For example, the oil company can have a problem at one of their facility causing a halt in production and hurting earnings. Consequently, even if the price of oil were to rise, the price of the stock may not rise in tandem. From a sharia prospective, the stock would be subject to the same non-permissible income and financial ratios as any other company.
The Role of Commodities in a Portfolio
There are 2 main advantages of including commodities in a portfolio:
- Diversification: Commodities have generally exhibited low correlation with other asset classes (i.e. stocks and bonds), therefore giving the possibility to diversify portfolio risk. The drivers of commodity prices (based primarily on global supply and demand) differ from than the drivers of stocks (namely earnings growth). The relationship between stocks and commodities can even turn sharply negative during times of crisis, as investors sell off stocks and purchase safe haven commodities (i.e gold) as investors choose real assets over paper assets. Nonetheless, commodity prices are not totally resistant to the business cycle. For example, the demand for oil and metals can drop during a recession causing pricing to decline.
- Inflation Hedge: Inflation is the rate at which prices of goods rise over a period of time and is of great importance to investors. Investments may not be able to keep up with the rise in the price of goods this eroding the purchasing power. To mitigate this, the value of the investments should rise at the same rate (if not better) as the rate of inflation. For example, cars may increase due to a rise in the price of metals that are used in its production. In other words, inflation and commodity prices often move in sync so an investor that holds commodities will see a rise in their portfolio value just as inflation is increasing, this allowing the portfolio to maintain its purchasing power.
There are 2 main disadvantages of commodity investing:
- No Income: Unlike stocks and fixed income, commodity’s are not income generating assets so they do not pay any dividends and/or interest. The total return (or loss) on commodities is solely based on price appreciation (or depreciation) of the underlying price of the asset.
- Highly Volatile: Historically commodities have been the most volatile asset class around. Because the drivers of commodities is a balance between demand and supply, we do get periods of a severe unbalance causing a major swing in prices that can lead to extreme levels. For example, contrary to popular belief even gold can be a risky asset to own. From 2009 to 2011, gold prices doubled reaching an all time high of $1,917 however subsequently dropped by 50% over the next 3 years.
I typically find that the average Muslim investor has an inherent bias towards investing in commodities vs the average non-Muslim. The reasons can be from the fact that a lot of Muslim countries typically have a commodity based economies, to the preference of having a real asset that’s easier to understand (vs a paper stock) or even for sharia compliance reasons. However, at ShariaPortfolio we believe that commodities play an important part of a well diversified portfolio as a piece of a puzzle rather than be a core holding. Because of their volatile nature, a good portfolio manager should monitor and rebalance actively to reduce risk. For more questions and/or details, please speak to your Financial Advisor.
Investing in securities involves risk, and there is always the potential of losing money when you invest in securities.
Halal compliant investments, diversification and asset allocation do not ensure a profit or protect against loss.
This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.