INSIGHTS ON INVESTING IN COMMODITIES

Transcription

1 PRUDENTIAL INVESTMENTS» MUTUAL FUNDS INSIGHTS ON INVESTING IN COMMODITIES WHITE PAPER NATURAL RESOURCES STOCKS HOLD THE LONG-TERM EDGE Although commodities may benefit an investment portfolio by offering a possible hedge against inflation, enhanced diversification, and potentially improved performance, commodities can be volatile and are often considered speculative investments. However, natural resources stocks may also provide these very same potential benefits. This paper explores the pros and cons of these two asset classes and the long-term factors that have historically favored natural resources stocks.

2 COMMODITIES AND NATURAL RESOURCES STOCKS Investments in commodities are commonly done through derivative contracts in which one party agrees to buy or sell a set amount of a commodity from another party at a specific date and price. Natural resources stocks are the equity securities of companies involved in the exploration, mining, production, transportation, storage, or processing of commodities. These very different approaches to obtaining exposure to commodities result in variations in performance, taxes, volatility, and other areas. Key differences are highlighted below. PERFORMANCE VOLATILITY Natural Resources Stocks Generally outperform commodity futures over the long term (see page 3). Can be moderately high during periods when investors are risk averse to equities (see page 10). Commodities Can be substantial on both the up and down sides during short-term periods. Can be extremely high during short-term periods that are driven by unforeseen economic, environmental, and/or political events (see pages 4 and 5). DIVERSIFICATION A company may have exposure to one or more type of commodity. You can choose exposure to specific commodities (see page 4). CORRELATION Moderate for stocks. Very low for bonds (see page 3). Low for stocks. Very low for bonds (see page 3). YIELD May pay a dividend. Do not pay a dividend. TAXES Short-term capital gain distributions are taxed at ordinary income rate. Long-term capital gain distributions are taxed at a maximum rate of 20%. Beginning in 2013, capital gain distributions may also be subject to an additional 3.8% Medicare tax. Source: IRS. Gains in investments of physical gold or silver are taxed at a maximum rate of 28% because these investments are considered collectibles by the IRS. Gains in investments of commodity futures are split into two tax brackets: 60% of gains are classified as long-term capital gains; remaining 40% are classified as short-term capital gains. Source: IRS. Neither Prudential Financial, its affiliates, nor their licensed sales professionals provide legal or tax advice. Please consult your legal and tax advisors for advice concerning your particular situation. Investing in natural resources involves risks. Some investments have more risk than others, such as investing in derivative securities, which may carry market, credit, and liquidity risks, and leverage, which may exaggerate an increase or decrease in the net asset value. Past performance is not a guarantee of future results. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. Commodities are subject to the risk of earthquakes, floods, and other acts of nature that can affect the overall supply of natural resources in a given area and also impact the value of companies that deal in them. Investing in commodities involves special risks. Risks associated with investing in foreign countries include inflationary pressures and social and political events. COMMODITIES 2

3 Key portfolio statistics on commodities and natural resources stocks: As of 12/31/14 Natural Resources Stocks 1 Commodities 2 Difference Performance (Average Annual Returns) 1-Year Year Year Year Year Risk (Standard Deviation) 1-Year Year Year Year Year Risk-Adjusted Return (Sharpe Ratio) 1-Year Year Year Year Year Calendar-Year Returns Max Gain/Loss for Past 15 years Best 3-month return 38.23% 32.63% Worst 3-month return 38.94% 47.00% Number of rolling 3-month periods of 10% or better Number of rolling 3-month periods of 10% or worse Correlation 5-year correlation to S&P year correlation to S&P year correlation to Barclays Aggregate Bond Index year correlation to Barclays Aggregate Bond Index The returns shown do not include the effects of charges, expenses, or taxes. If they did, the returns shown would have been lower. Past performance is not a guarantee of future results. An investment cannot be made directly in an index. See page 11 for glossary of terms and page 12 for index definitions. 1 Represented by the S&P North American Natural Resources Index. 2 Represented by the S&P GSCI. Source: Calculated by Prudential Investments LLC using data presented in Morningstar software products. All rights reserved. Used with permission. COMMODITIES 3

4 COMMODITIES A CLOSER LOOK A POTENTIAL HEDGE AGAINST UNEXPECTED EVENTS Geopolitical or weather-related events can have significant impact on the markets. For example, expectation of war between the U.S. and Iraq in 2003 clouded the markets with uncertainty over the impact military action would have on energy supplies. For the three months leading up to the proposed United Nations resolution for military intervention on February 24, 2003, U.S. stocks plummeted while prices for oil and natural gas skyrocketed. At the same time, commodity indexes had positive performance, particularly the S&P Goldman Sachs Commodity Index, which is dominated by energy weightings. Following the swift U.S. victory in Iraq, energy prices stabilized and the U.S. equity markets bounced back, while commodities declined. This heightened volatility illustrated the importance of diversification when investing in commodity-based securities. 90 days before the U.N. Resolution (11/24/02 to 2/24/03) 34.5% 10.1% 1.6% 31.2% 90 days after the U.N. Resolution (2/25/03 to 5/25/03) 12.6% 9.2% 11.8% INVESTORS CAN FOCUS ON SPECIFIC COMMODITIES A key advantage of commodity investing is the ease with which an investor can get exposure to specific commodities. For example, if investors believe soybeans will begin to appreciate significantly due to extreme weather forecasts, they can buy soybean futures contracts. Getting specific exposure to soybeans via stocks is much more challenging. The following commodities are listed in the S&P Goldman Sachs Commodity Index (S&P GSCI). S&P GSCI Energy Crude Oil Unleaded Gasoline Heating Oil Natural Gas Brent Crude Gas Oil Industrial Metals Aluminum Copper Nickel Zinc Lead Precious Metals Gold Silver Source: Standard & Poor s. As of 12/31/2014. Agriculture Wheat Corn Soybeans Cotton Sugar Coffee Cocoa Kansas Wheat Livestock Live Cattle Lean Hogs Feeder Cattle 20.3% Price S&P 500 Natural S&P GSCI Price S&P 500 Natural S&P GSCI of Oil Index Resources Index of Oil Index Resources Index Stocks Stocks Source: Calculated by Prudential Investments LLC using data presented in Morningstar software products. All rights reserved. Used with permission. Price of oil is represented by the West Texas Intermediate Crude Oil Index and natural resources stocks by the S&P North American Natural Resources Index. These indexes are unmanaged. Past performance is no guarantee of future results. An investment cannot be made directly in an index. See index definitions on page 12 for more information. COMMODITIES 4

5 PRICING AND PERFORMANCE BEHAVIOR OF COMMODITIES While prices for some of the most popular commodities have increased dramatically over the past 10 years, short-term price behavior is subject to wide fluctuations. Another important point to be aware of is that while commodity prices have had substantial appreciation over the past decade, an investment in commodities futures may not be able to match this appreciation due to a phenomenon within the futures market known as contango. 10-YEAR CUMULATIVE PERFORMANCE OF POPULAR COMMODITIES Each Commodity s Return is Represented by Its Respective GSCI Spot Index 170% 128% 98% 92% Gold Silver Copper Wheat 60% Source: Calculated by Prudential Investments LLC using data presented in Morningstar software products as of 12/31/2014. All rights reserved. Used with permission. Past performance is no guarantee of future results. An investment cannot be made directly in an index. Sugar See page 12 for respective index definitions. COMMODITY PRICES CAN BE HIGHLY VOLATILE Gold Silver Copper Wheat Sugar Best 3-month return 29% 73% 65% 57% 59% Dates 11/01/2008 to 01/31/ /01/2011 to 04/30/ /01/2006 to 05/31/ /01/2007 to 09/30/ /01/2005 to 01/31/2006 Worst 3-month return 24% 45% 52% 32% 49% Dates 03/30/2013 to 06/27/ /01/2008 to 10/31/ /01/2008 to 11/30/ /01/2008 to 10/31/ /01/2010 to 04/30/2010 Source: Calculated by Prudential Investments LLC using data presented in Morningstar software products. All rights reserved. Used with permission. Past performance is no guarantee of future results. An investment cannot be made directly in an index. There are geopolitical and speculative risks inherent in commodities investing. From a geopolitical perspective, the world s natural resources are located in various continents, and the jurisdiction over these commodities lies with sovereign governments, foreign companies, and many other entities. Disagreements over the control of natural resources are routine. Host countries can and do expel foreign companies involved in the production and distribution of that country s natural resources. Also, the commodities markets are run by traders whose primary interest is in making short-term profits by speculating whether the price of a security will increase or decrease. COMMODITIES 5

6 CONTANGO S POTENTIAL ADVERSE EFFECTS Sometimes a futures contract s price (the expected value of the security) can be higher than the current spot price (the explicit value of the security at any given time in the marketplace) of the commodity. When this happens, a market is said to be in contango. Conversely, when the contract s price is lower than the current spot price, a market is said to be in backwardation. As contracts approach expiration, portfolio managers who wish to maintain their exposure need to roll their futures positions by selling the expiring contract and buying a new one. When a market is in contango, the portfolio will experience a negative roll yield caused by purchasing a new contract at a higher price, which can erode a portfolio s returns. When a market is in backwardation, the portfolio will experience a positive roll yield caused by purchasing a new contract at a lower price, which can benefit a portfolio s returns. EXAMPLE OF CONTANGO Futures Curve for Aluminum as of 3/11/2011 Contango develops when supply is constrained and investors generally believe that prices will continue to rise over the long run because of tight supply/demand fundamentals. Thus, longer-term contracts have seen higher prices than short-term contracts. Contango is a critical factor that investors should be aware of. This is particularly true when a portfolio management team is obligated to track a particular commodity index and thus must continually roll over from one expiring contract to another to maintain exposure. Futures contracts are investments that involve derivative securities, which may carry market, credit, and liquidity risks. Futures contracts are risky investments. Any given buying or selling futures contracts transaction may result in unlimited losses to principal. EXAMPLE OF BACKWARDATION Futures Curve for Sugar as of 3/11/2011 $3,000 $30 2,900 2, Settlement Price 2,700 2,600 Settlement Price 24 2, ,400 2, /11 7/11 10/11 3/12 5/12 7/12 10/12 3/13 5/13 7/13 10/13 3/14 Expiration Date Expiration Date The graphs above are hypothetical examples and not representative of any specific investment. Past performance does not guarantee future results. COMMODITIES 6

7 NEGATIVE ROLL YIELDS HAVE HAD A MAJOR IMPACT ON PERFORMANCE The performance of the S&P GSCI Spot Index is based solely on changes in the spot prices of the underlying commodities. The performance of the S&P GSCI Total Return (TR) Index is based on: Changes in the spot prices of the underlying commodities Roll yield Collateral yield (interest earned on the collateral for futures contracts, often invested in T-bills). In recent years, negative roll yield has eroded the performance of the S&P GSCI TR Index, a common benchmark that commodity managers try to emulate. Some portfolio managers may use different yield roll techniques to help counteract these effects, but they are not guaranteed to be successful. IMPACT OF NEGATIVE ROLL YIELDS 40,000 S&P GSCI TR S&P GSCI Spot 30,000 20,000 10, /01/05 12/31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/2014 Source: Calculated by Prudential Investments LLC using data presented in Morningstar software products as of 12/31/2014. All rights reserved. Used with permission. Past performance is no guarantee of future results. An investment cannot be made directly in an index. See page 12 for index definitions. AVERAGE ANNUAL RETURNS Performance S&P GSCI Total Return Index S&P GSCI Spot Index Difference 1-year 33.06% 33.87% 0.81% 3-year 12.86% 13.45% 0.59% 5-year 6.54% 4.44% 2.11% 10-year 2.96% 4.39% 7.36% Source: Calculated by Prudential Investments LLC using data presented in Morningstar software products as of 12/31/2014. All rights reserved. Used with permission. The returns shown do not include the effects of charges, expenses, or taxes. If they did, the returns shown would have been lower. Past performance is no guarantee of future results. An investment cannot be made directly in an index. See page 12 for index definitions. COMMODITIES 7

8 NATURAL RESOURCES STOCKS A CLOSER LOOK HISTORICAL OUTPERFORMANCE VERSUS COMMODITIES Natural resources stocks have outperformed commodities: 129 out of 185 of the past 3-year rolling return periods, or 70% of the time. 121 out of 161 of the past 5-year rolling return periods, or 75% of the time. 96 out of 101 of the past 10-year rolling return periods, or 95% of the time. Source: Morningstar. As of 12/31/14. See below for more detail. DIFFERENCE IN 3-YEAR AVERAGE ANNUAL ROLLING RETURNS Natural Resources Stocks Outperform Commodities Outperform 20 09/01/96 to 08/31/99 09/01/98 to 08/31/01 09/01/00 to 08/31/03 09/01/02 to 08/31/05 09/01/04 to 08/31/07 09/01/06 to 08/31/09 09/01/08 to 08/31/11 01/01/11 to 12/31/14 DIFFERENCE IN 5-YEAR AVERAGE ANNUAL ROLLING RETURNS Natural Resources Stocks Outperform Commodities Outperform 20 09/01/96 to 08/31/01 09/01/98 to 08/31/03 09/01/00 to 08/31/05 09/01/02 to 08/31/07 09/01/04 to 08/31/09 01/01/07 to 12/31/11 01/01/09 to 12/31/14 COMMODITIES 8

9 DIFFERENCE IN 10-YEAR AVERAGE ANNUAL ROLLING RETURNS Natural Resources Stocks Outperform Commodities Outperform 2 09/01/96 to 08/31/06 09/01/97 to 08/31/07 09/01/98 to 08/31/08 09/01/99 to 08/31/09 09/01/00 to 08/31/10 09/01/01 to 08/31/11 01/01/03 to 12/31/12 01/01/04 to 12/31/13 01/01/05 to 12/31/14 Source: Calculated by Prudential Investments LLC using data presented in Morningstar software products as of 12/31/2014. All rights reserved. Used with permission. Rolling returns begin on the common inception date of 8/30/1996. Natural resources stocks are represented by the S&P North American Natural Resources Index. Commodities are represented by the S&P GSCI Index. These indexes are unmanaged. An investment cannot be made directly in an index. Past performance is no guarantee of future results. See page 12 for index definitions. NATURAL RESOURCES STOCKS DIVIDENDS MAY BENEFIT PERFORMANCE While futures do not pay dividends, stocks have that ability, although not all stocks pay a dividend and dividends are not guaranteed. While past performance does not guarantee future results, natural resources stocks have a 2.5% yield (as of 12/31/2014), which may help provide a higher total return. Source: FactSet. Investing in natural resources involves risks. Some investments have more risk than others, such as investing in derivative securities, which may carry market, credit, and liquidity risks, and leverage, which may exaggerate an increase or decrease in the net asset value. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. COMMODITIES 9

10 HOW NATURAL RESOURCES STOCKS MAY OUTPERFORM While natural resources stocks certainly benefit from the heightened demand for commodities, their share prices also can be influenced by factors that are indifferent to the particular commodity that they specialize in. For example, natural resources companies can use cutting-edge technology to make new discoveries of commodities around the globe, thus enabling them to increase production and earnings growth, even if the commodity price itself remains steady. As the chart below illustrates, the long-term correlation between gold mining stocks and the price of gold has been historically in sync. However, there can be times when an investment in gold mining stocks may differ, sometimes dramatically, from gold prices. ROLLING 12-MONTH RETURNS Gold Mining Stocks Price of Gold /01/02 to 01/31/03 02/01/03 to 01/31/04 02/01/04 to 01/31/05 02/01/05 to 01/31/06 02/01/06 to 01/31/07 02/01/07 to 01/31/08 02/01/08 to 01/31/09 02/01/09 to 01/31/10 02/01/10 to 01/31/11 02/01/11 to 01/31/12 01/01/12 to 12/31/12 01/01/13 to 12/31/13 01/01/14 to 12/31/14 Source: Calculated by Prudential Investments LLC using data presented in Morningstar software products as of 12/31/2014. All rights reserved. Used with permission. CALENDAR-YEAR PERFORMANCE (%) Year Price of Gold Gold Mining Stocks Source: Calculated by Prudential Investments LLC using data presented in Morningstar software products as of 12/31/2014. All rights reserved. Used with permission. Past performance is no guarantee of future results. Gold mining stocks are represented by the FTSE Gold Mines Index. The price of gold is measured by the London Gold Fix. An investment cannot be made directly in an index. See index definitions on page 12 for more information. COMMODITIES 10

11 CONCLUSION An investment in commodities or natural resources stocks can play an important role in investors portfolios. Yet these two asset classes have distinct attributes that investors should be aware of. Commodities can offer sophisticated investors a chance to take advantage of select opportunities, especially during short-term market movements that favor them over traditional equity markets. However, because of the effects of contango on commodity futures, long-term performance historically has tended to favor natural resources stocks since these companies growth does not solely depend on the appreciation of commodity prices. In addition, the tax treatment and possibility for dividends further the case for natural resources stocks. A WORD ABOUT RISKS Investing in either commodities or natural resources has its risks. Investing in natural resources involves risks. Some investments have more risk than others, such as investing in derivative securities, which may carry market, credit, and liquidity risks, and leverage, which may exaggerate an increase or decrease in the net asset value. Past performance is not a guarantee of future results. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. Commodities are subject to the risk of earthquakes, floods, and other acts of nature that can affect the overall supply of natural resources in a given area and also impact the value of companies that deal in them. Investing in commodities involves special risks. Risks associated with investing in foreign countries include inflationary pressures and social and political events. Futures contracts are investments that involve derivative securities, which may carry market, credit, and liquidity risks. There is no guarantee that derivative strategies will be successful, that the instruments necessary to implement them will be available, or that they will not lose money. The use of derivatives such as futures, options, and various types of swaps involves costs and can be volatile. They are used to try to predict if the underlying investment will go up or down at some future date. The commodities markets are characterized by traders who are primarily interested in making profits. They bet on whether the price of a security will rise or fall, increasing market volatility. GLOSSARY OF TERMS Backwardation When the contract s price is lower than the current spot price of the commodity. Collateral Yield Interest earned on the collateral for futures contracts, often invested in T-bills. Contango When the contract s price is higher than the current spot price of the commodity. Correlation The statistical measurement of the relationship between two asset classes. Futures Contract Price The expected value of the security. Negative Roll Yield When a new contract is purchased at a higher price while the market is in contango, which can erode a portfolio s returns. Positive Roll Yield When a new contract is purchased at a lower price while the market is in backwardation, which can benefit a portfolio s returns. Rolling Returns Returns of an investment over several time periods. Sharpe Ratio This statistic measures the quality of the returns for an investment on a risk-adjusted basis over a given period. It is defined as the excess returns of an investment divided by the standard deviation of returns. Excess returns are the returns of the investment minus the risk-free rate of return offered in the market, typically measured by short-term government instruments such as 3-month T-bills. Standard Deviation This statistic measures the volatility of a stream of data compared to its average value. Applied to investment performance, standard deviation measures how choppy the monthly returns are over a period of time. 66% of all monthly values would fall within one standard deviation of the average, while 95% of all values would fall within two standard deviations of the average. Spot Price The explicit value of a security at any given time in the marketplace. COMMODITIES 11

12 INDEX DEFINITIONS The indices are presented to provide you with an understanding of their historic long-term performance and are not presented to illustrate the performance of any security. The indices defined below are unmanaged. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Individual investor results will vary. The Barclays Aggregate Bond Index is an unmanaged index which covers the U.S. dollar-denominated, investment-grade, fixed rate, taxable bond market of SEC-registered securities. West Texas Intermediate Crude Oil Index is the underlying commodity of the New York Mercantile Exchange s oil futures contracts. S&P 500 Index is an unmanaged index of 500 of the largest U.S. stocks in a variety of industry sectors. S&P North American Natural Resources Index measures the performance of U.S.-traded natural resources-related stocks. S&P GSCI Index is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. Individual components qualify for inclusion in the S&P GSCI on the basis of liquidity and are weighted by their respective world production quantities. S&P GSCI Total Return (TR) Index measures a fully collateralized commodity futures investment that is rolled forward from the fifth to the ninth business day of each month. S&P GSCI Spot Index measures the price movements of the underlying commodities within the index. The FTSE Gold Mines Index encompasses all gold mining companies that have a sustainable, attributable gold production of at least 300,000 ounces a year and that derive 51% or more of their revenue from mined gold. The London Gold Fix represents the price of gold, fixed twice daily in London by the five members of the London gold pool, all members of the London Bullion Market Association. Silver is represented by the S&P GSCI Silver Spot Index, which tracks the price of the nearby silver futures contracts. Gold is represented by the S&P GSCI Gold Spot Index, which tracks the price of the nearby gold futures contracts. Copper is represented by the S&P GSCI Copper Spot Index, which tracks the price of the nearby copper futures contracts. Crude oil is represented by the S&P GSCI Crude Oil Spot Index, which tracks the price of the nearby crude oil futures contracts. Sugar is represented by the S&P GSCI Sugar Spot Index, which tracks the price of the nearby sugar futures contracts. Corn is represented by the S&P GSCI Corn Spot Index, which tracks the price of the nearby corn futures contracts. ABOUT PRUDENTIAL INVESTMENTS Prudential Investments is dedicated to helping you solve your toughest investment challenges whether it s capital growth, reliable income, or protection from market volatility and other risks. Through ever-changing markets, we strive to be a leader in a broad range of investments to help you stay on course to the future you envision. Our investment professionals also manage money for major corporations and pension funds around the world, which means you benefit from the same expertise, innovation, and attention to risk demanded by today s most sophisticated investors. Together they manage more than $884 billion in assets (through 12/31/2014). We believe the knowledge and experience of a financial professional provides a valuable advantage, so we make our products available through financial advisors. We are part of Prudential Financial, a company America has been bringing its challenges to for 140 years. Bring us yours. FOR MORE INFORMATION, contact your financial professional or visit prudentialfunds.com. Financial professionals: Call the Prudential Investments Sales Desk at (800) Consider a fund s investment objectives, risks, charges, and expenses carefully before investing. The prospectus and summary prospectus contain this and other information about the fund. Contact your financial professional to obtain the prospectus and summary prospectus. Read them carefully before investing. Mutual funds are distributed by Prudential Investment Management Services LLC, a Prudential Financial company Prudential Financial, Inc. and its related entities. Prudential Investments LLC, Prudential, the Prudential logo, Bring Your Challenges, and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide. MUTUAL FUNDS: Are not insured by the FDIC or any federal government agency May lose value Are not a deposit of or guaranteed by any bank or any bank affiliate PI3332 Expiration: 12/31/2016