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Commodities are the fundamental building blocks for the goods humans consume on a daily basis such as gas, corn, wheat and sugar. These can be further categorized as ‘soft’ commodities such as sugar which is grown and ‘hard’ commodities such as crude oil is extracted.
The sale and purchase of commodities has drastically changed due to new and innovative electronic contracts allowing for risk to be mitigated on the part of producers.
This development has allowed for the participation of investors to consider this as an inflation-hedging asset class due to the elasticity of certain commodities. In this blog, we discuss how to access commodities in a sharia-compliant manner and whether there is a case for having commodity exposure in an investors portfolio.
Previously the process of selling commodities involved a physical exchange of goods between buyer and seller. In the 1800s, the demand for fairer pricing and easier exchange for these homogeneous commodities meant that standardized contracts were put in place to allow for smoother handling of these commodities.
Now, these contracts mean that commodities can be traded electronically, allowing producers to offload price risk to other financial participants (1). Risk is offloaded through futures contracts which is an agreement to buy commodities at a future set price and date. Futures are traded on an array of metals and energy products.
Therefore commodities have developed significantly as an asset class, allowing for index-linked exposure to the commodities. Even to this day, the number of commodities keeps on increasing, with more than 40 new commodities contracts being introduced from 2014 to 2018 (7).
Over the last 30 years, developed markets have experienced stable inflation matched with falling rates of interest. This has led to stellar performance from asset classes such as bonds and stocks. However, commodities offer the ability to hedge against inflation.
The inflation hedging works as the consumer price index (CPI), a prominent measure of inflation, measures a basket of goods’ prices such as petrol and electricity. Therefore higher inflation is suggestive of the idea that the cost of these commodities have increased in the representative basket.
Inflationary spikes lower the purchasing power of cash flows hence there are falling profit margins for businesses through weakened demand. In turn, equities are negatively affected as an asset class, whereas inflationary pressures appreciate the price of commodities and ‘real’ assets.
For example, inflation in the 70s, which had a 6.8% average inflation rate, led to a large positive return for commodities. Although sustained inflation at this level is unlikely, or so we think, shorter term inflation spikes affect portfolios (3). Nonetheless, inflation spikes have occurred 8 times in last 45 years, diminishing purchasing power of accumulated wealth, building the case for some exposure to commodities in a portfolio. Schroders estimates exposure to commodities can increase returns by 2% per annum (4).
Although we have covered the link between inflation and commodity prices, many exogenous factors affect commodity prices which can trigger ‘supercycles’, at varying levels dependant on the commodity.
A supercycle is when there is a structural change which leads to a change leading to rise of long term price for 10 to 35 years. Economic strength of nations influence the price of commodities and trigger a supercycle. For example, the industrial revolution of emerging economies such as China and India previously led to unprecedented demand however the growth of the Chinese economy has started to plateau to some extent.
Current geopolitics suggests that energy commodities may be entering a supercycle, having been somewhat dormant post the global financial crisis. Western sanctions have sought to significantly limit Russian imports, driving up the cost of energy due to limited supply.
With limits as to how quickly extraction of oil can be extracted, there may be a longer term boom in energy commodities. Despite this, the aforementioned slower demand in China, matched with a US engineered recession through higher interest rates, can limit the demand for these commodities, according to Schroders (6).
There are many ways in which one can increase exposure to commodities in a portfolio. Some methods provide ownership to the physical commodity, which is sharia compliant, whereas other methods operate through exposure to futures and options-based contracts which are impermissible.
One way in which an investor can get exposure to commodities is by investing in the stock market in ETFs (Exchange-traded Funds) or ETCs (Exchange-traded Commodities). Secondly, one can also build an indirect position in commodities through exposure to certain stocks in the equity markets. For instance, many oil, gas and agricultural companies are publicly listed and will outperform the broader market when the commodities are performing well.
Another method in which an investor can have access to commodities is through Islamic Commodity funds. Investors subscribe to a fund which seeks to purchase different commodities, for resale.
Profit is then generated when the commodity is sold, with gains distributed to subscribers. However, the commodity must be owned and in possession when sold forward and have a fixed price (11). Generally, Islamic Commodity funds have higher fees and are limited to the realms of Islamic finance and not the broader financial markets. As a consequence of this, gaining exposure through this method is slightly more complex and requires larger capital positions.
Read more about: Main Islamic Financing Methods
ETFs are only sharia compliant if they invest directly in the underlying commodity and avoid futures contracts as there is uncertainty over the delivery of the underlying asset.
The sale of the asset cannot go ahead without possession of the asset, according to Sharia principles. Therefore, ETFs and ETCs which are physically backed by the commodity are permissible. Generally, precious metal commodities are easily stored in vaults however this is not the case for soft commodities. Instead, wheat for example, would spoil therefore ETCs use complex derivatives to track performance, which are generally classed as impermissible (9, 10) due to the concept of gharar.
Read More About: Halal Investment
Two examples of Sharia compliant physical ETCs are the Global X Physical PM Basket (PHPM: LSE) and the Wisdomtree Physical Gold (PHAU: LSE). The former offers investors a cost-efficient and secure method to access returns equivalent to the movements in the spot price of the metals. PHPM has provided investors with 12.1%, 22.1% and 57.1% returns over the 1, 3 and 5 year timeframes when considering cumulative performance (12). Similarly, the Physical Gold ETC (PHAU) has returned 0.38%, 22.05%, and 38.63% over the 1, 3 and 5 year timeframes.
Furthermore, when gaining exposure to commodities through equity market exposure, one must understand the operational aspect of the business. Prior to investing, due diligence is required to confirm there are not other problems with the business, such as poor management. In order to confirm whether a certain company’s financials are sharia compliant is by searching the company through a trusted halal stock screener. In sum, the latter is a more active investing approach to investing in commodities in comparison to ETCs.
Exposure to commodities provides access to inelastic goods which improve risk-adjusted returns, particularly in a high inflationary environment. Although there is a strong investment case for exposure to commodities, it can be hard to achieve from a sharia-permissible manner, particularly for ‘soft’ commodities.
We have mentioned what may affect the price of commodities, however, there are political, economic and foreign currency risk which are also undertaken when investing in commodities. Therefore, we recommend an approach whereby fundamentally strong stocks are used to gain some exposure to ‘soft’ commodities, and ETFs to ‘hard’ commodities, as a minority stake in an overall balanced portfolio.
References
Strategic Case For Commodities Investment
Managing Industrial Commodity Price Risk
