Commodity investors: how to hedge your US dollar exposure

For quite some time now, low interest rates have prompted investors to look for investments with the potential to deliver decent levels of growth.

If anything, this desire has intensified in the past year or so as inflation in the UK has picked up. Annual Consumer Price Inflation (CPI) – the measure of price growth favoured by the Bank of England – has risen to 3.0 per cent[1]. This means that, currently, investments must deliver a net return of at least 3 per cent for investors to stand still and maintain their current purchasing power. Any less, and real returns will be negative. Investors’ wealth and purchasing power will diminish over time, even though their investments might be making steady positive returns.

Against this background, it seems more important than ever for British savers to identify investments that can generate returns above inflation. And with this goal in mind, investors might consider asset classes that have historically performed well during periods of rising inflation.

Commodities and why to invest in them

The term ‘commodities’ describes a large and diverse group of products. Fossil fuels such as oil and natural gas are included, as are industrial metals – aluminum, nickel and copper, for example – and precious metals. A wide range of agricultural produce is also included under the ‘commodities’ umbrella; wheat, corn, soybeans, sugar, coffee and cocoa, etc. All of these products have their own unique price drivers, many of which are unrelated to one another. This makes commodities particularly interesting from a diversification perspective.

Indeed, given potential volatility in other asset classes, the merits of including an allocation to commodities within a well-diversified investment portfolio have become increasingly apparent. While commodity prices can be cyclical in nature, they typically have low or negative correlations with traditional asset classes. For example, the correlation of monthly returns on the S&P 500 Index and the Bloomberg Commodity Index was just 0.22 between 2013 and 2017. Some commodities, such as gold, have a negative correlation with equities (the correlation between gold and S&P 500 Index monthly returns between 2013 and 2017 was -0.05).[2] Adding an exposure to commodities can therefore be an effective way of diversifying existing investment strategies and can help reduce overall portfolio volatility.

Separately, commodity prices tend to have a positive correlation with inflation, suggesting returns should be reasonable during inflationary periods. Precious metals considered to have intrinsic value due to finite supplies – such as gold, platinum and silver – have, at times, performed well when inflation has picked up. In fact, during periods of high inflation and equity market downturns, commodities have historically outperformed most other major asset classes. For example, looking over the past 10 years, during the worst 24 months of performance in the S&P 500 (where on average the Index fell 5.8 per cent), gold returned 2.8 per cent on average.

Historical performance is not an indication of future performance and any investments may go down in value.

How investors can access commodities

Due to the significant costs involved and storage impracticalities, only the largest international investors buy physical quantities of commodities. Some use financial derivatives, such as futures contracts, whose value fluctuates according to underlying commodity prices. Others buy shares in energy and mining companies, whose performance may be linked to the prices of oil, metals, or other commodity types.

For everyday investors, exchange traded products (ETPs) arguably provide an easy and cost-effective way of obtaining desired exposure to commodities. An extensive range of commodity-based ETPs is available. For convenience, some provide broad exposure to a diversified range of commodity types within a single vehicle. Other products focus on individual commodity types, suiting investors with insights into particular areas of the market.

Hedging your commodity exposure

Given commodity prices are almost always quoted in US dollars, currency movements can have a significant influence on returns from commodity-based ETPs. The sterling exchange rate is a particularly important consideration for UK-based investors, because returns from investments priced in other currencies are diluted when the pound strengthens.

As a hypothetical example, let’s consider a UK-based saver who decided to invest in a US dollar-denominated platinum ETP. A year after doing so, the platinum price had risen 10 per cent. Even after transaction costs and management charges, the investor was happy with their foresight and decision to invest. Over the same period, however, let’s assume the pound had increased in value by 15 per cent against the US dollar. The impact of this exchange rate movement would have more than offset the appreciation in the platinum price and resulted in a financial loss for the investor.

Nobody can accurately predict how sterling will fare going forward. What we do know is that the pound continues to be affected by a number of uncertainties; many of them Brexit-related. With negotiations between the UK and other EU member states expected to continue for some time yet, there appears to be a fair chance that currency volatility will persist for the foreseeable future.

Volatility in currency markets is also linked to inter-relationships between macroeconomic activity levels globally. Economic conditions – and investor sentiment more broadly – can change quickly, often resulting in significant exchange rate movements. Ideally, investors need to consider ways of protecting their investments from these potential fluctuations.

Thankfully, many commodity-based ETPs in the UK are now available in hedged versions. These products reduce currency risk, effectively providing insurance against a stronger pound and its ability to erode, or even eliminate, increases in underlying commodity prices. All of the currency hedging is managed by the ETP provider and the cost is included in standard management charges. With hedged products, investors can rest assured that currency movements will have no bearing on their investment and that returns will be driven purely by movements in underlying commodity prices.

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[1]Office for National Statistics, January 2018

[2]Bloomberg; ETF Securities, February 2018