Portfolio Diversification - Diversify with Commodity Derivatives

Portfolio diversification is a concept used in the financial industry to describe how to get the most out of investing in various asset classes. "Don't Put All Your Eggs in One Basket," as the English proverb goes, indicates don't rely on one investment vehicle for profits because any unforeseeable occurrence can undermine the entire investment. As a result, diversification of your portfolios among several asset classes such as equities, commodities, currencies, and bonds protect you against the unanticipated market movement in one or more asset classes because they are independent of one another. Combining multiple sorts of financial products would provide portfolio diversity. The development of a diversified portfolio based on one's financial goals and risk tolerance is referred to as a portfolio diversification method. 

To diversify well, one needs to invest across different asset classes and within different options in an asset class. If most of your money is in one or two asset classes, it may be prudent to consider other asset classes. Then within each asset class, make sure your money is invested across the different options available. There are a variety of investment options available to help you invest your money and earn the best possible returns with the least amount of risk. Asset classes are broad categories that include but are not limited to, cash and cash equivalents, bonds, derivatives, equities, real estate, gold, commodities, mutual funds and alternative investments.

Comparison between equity and commodity derivatives

Historically, it is proven that commodities carry an inverse relation with other asset classes. When the global economic growth shows an improvement, then the demand for riskier assets such as bonds and currencies increase, and the demand for safe-haven securities such as gold decreases and vice versa. In the recent past, the have-haven investment i.e., gold reacted negatively to the rise in the dollar and bond yields. During the period of economic turbulence, gold attracts as a safe haven buying while the demand for metals and energy diminishes and vice versa. For example, in 2020, when the global equity market. Currencies and bond-market were under pressure because of the outbreak of COVID-19 across the globe, the demand for energy and metals was also down, which resulted in a fall in the prices to multi-year lows while the gold—a safe-haven metal—skyrocketed to hit an all-time high. 

Commodities available for trading on exchange platforms are categorized into bullion, metals, energy, and agricultural commodities. Under bullion, MCX offers trading in gold and silver; in energy - crude oil and natural gas while in the base metals sector, aluminium, copper, lead, nickel, and zinc are available for trading. Agricultural commodities available for trading at spices, mentha oil, cotton, castor seeds, soybean, soy oil, mustard seeds, etc. 

Additional Read: Commodities and its importance in investment portfolios

The history of the commodity derivatives market dates back to the 19th century with the establishment of the Chicago Board of Trade followed by the London Metal Exchange. In India, commodity trading was in existence in the late 19th century, however, the trading was suspended after independence because of various reasons. However, the organized regulated national-level commodity exchanges came into existence in 2003 with the incorporation of MCX and NCDEX. With the merger of erstwhile commodity market regulator i.e., Forward Markets Commission with the Securities and Exchange Board of India (SEBI), investors need not to worry about different trading accounts. Moreover, commodity market traders and investors are not required to open a Demat account unless and until he/she is willing to give/take delivery of the commodities.  

Under commodity derivatives in India, futures and options on commodity futures as well as goods are available for trading. Further, the regulator had permitted the launch of the index on commodity futures and accordingly MCX has launched BULLDEX-Bullion Index; ENRGDEX-Energy Index, and METLDEX-Metal Index, which is gaining traction among the investors. Since commodities are considered as an alternate asset class, it is having its own price action based on supply-demand, economic conditions, and monetary and fiscal policies. As mentioned above, commodities are having a strong correlation with the equity market other than gold, hence, it makes a perfect portfolio combination among retail traders. Commodity Indices solve most of the challenges faced by commodity traders who trade in a single commodity. 

Additional Read: Role of Commodity Market In India

For a retail investor, index and options are the most suitable commodity market instruments to begin with. Commodity investment can be emotionally connected to the investor as he/she uses all these commodities in their day-to-day life. During a market downturn, a well-diversified portfolio can better absorb the shocks. When you invest in various asset types, the risk is spread out. In addition, the underperformance of one asset class is compensated by the performance of another asset class. Simply, a well-diversified portfolio allows you to better manage your losses. The performance of the listed companies who are predominantly producers and users of commodities such as bullion, metals, and energy is dependent on the price of the commodities, hence, it creates a stronger correlation between the commodity and stock of the commodity-based companies. This nature of interrelation is to be captured in diversifying the portfolio.