Your Commodity Guide
This page offers a comprehensive guide on the best way of investing in commodities. Private investors often wonder about how to invest in commodities in 2011, yet they struggle to get good information from their branch manager (who only wants to sell them expensive mutual funds) or from government (which focuses on dispensing advice for savings, not investments). This is why I created this commodities investing guide. For trading equities, see How to Invest in Shares.
Commodities are physical goods that have a real use in the economy. A common misconception is that commodities are raw materials, such as coal, gas, oil and lumber. However a range of processed materials are also included, such as cotton, coffee and would you believe it, frozen orange juice! For a complete list of commodities, see ‘A List of Commodities You Can Invest In‘. The hallmark characteristics of commodities are standardisation (all barrels of Brent Crude oil are the same) and a limited supply.
Why Are Commodities Traded in the Financial Markets?
The Original Exchanges
The history of commodities trading is lengthy, and if you’re interested in this topic I recommend you Google around and find out more about this fascinating area. Originally, the purpose of a commodities market was to match up buyers of commodities with their sellers. Contracts would specific the quantity and date of delivery of a good, and when a buyer purchased the contract they were effectively placing an order for the goods. These were called forward contracts. If the buyer decided they no longer wanted to receive the good, they could sell the forward contract on to another party. This system ensured that a) Suppliers always found a buyer and b) Buyers could repudiate on their obligations by passing them on to someone else.
Exchanging forwards well ahead of the date of delivery also meant that market participants were able to fix prices in advance, locking in their profit margins and removing some of the volatility and risk from purchasing goods in a market where the prices are ever-changing.
It wasn’t long before wealthy speculators spotted an opportunity to turn a profit in this market. If a speculator purchased a forward contract to buy 1,000 barrels of oil in 365 days for $20,000, they now owned an asset worth $20,000. If the market price for oil spiked to $30, then the speculators could realise a profit by selling the contracts on to other parties (at $30,000). They would always sell the contracts on before the delivery date, as they had no intention of taking physical possession of such goods.
The Financial Markets Developed
As more and more speculators used the markets, separate ‘instruments’ were used to make bets on commodity price movements. Financial instruments called ‘Futures’ and ‘Options’ and ‘Swaps’ were much more efficient tools for speculators, and began to dominate speculative trading from that point onwards. Futures and options are known as derivatives. Derivatives are financial instruments that derive their value from something else. In this case, the price object is the commodity. Two speculators that hold opposite views on the movements of commodities could make a contract with each other to pass money across on a specified date to the speculator that ‘won the bet’. Put simply, this is at the core of how derivatives work. When one party makes a gain, the other makes an equal loss – as if each had been holding opposite positions in the same asset, but without any actual asset required.
Futures and options remain the key methods for professional and institutional investors to profit from the commodities markets, however they are difficult and complicated to trade as a private investor. They are not out-of-bounds for someone who has the time, money and passion for trading in these instruments, but these are simply not suitable for beginners or moderately experienced investors.
How do Private Investors Trade Commodities?
Mutal Funds, OEICS and Closed Unit Trusts, ETFs, ETNs & ETCs
Private investors primarily use pooled investments to gain access to commodity prices. In other words, they invest in funds managed by professionals, to deal with derivatives or physical goods on their behalf. These funds take many different legal forms, such as the ubiquitous mutual funds, and the uncommon Exchange Traded Commodities (ETCs). The differences between all these types of pooled investments will be the subject of another blog post. For the intensive purposes of this commodities guide – all of the above can be purchased either through your broker or fund supermarket. All offer you the opportunity to own a share in a fund that purchases assets.
Physical Holdings Versus Synthetic Holdings
Rather than worrying between the subtle differences between how the above pooled funds are structured, it is the way that the fund invests in commodities that is important.
Physical pooled investments physically hold the commodity in question. This is only economically viable for high value, non-perishable commodities such as precious metals. In fact, precious metals are the only type of commodity that would be cost effective to store. If you invest in a mutual fund that purchases gold bars, these will be stored in a secure lockup in a bank vault, and you will own a few units of that gold quantity.
Synthetic pooled investments use derivatives to ‘replicate’ the ownership of the commodity in question. You will remember from the example above, that when a speculator purchases a contract to buy oil at a set price, they can benefit from gains in the spot price just as if they held the barrels themselves. Derivatives therefore offer a very efficient method to add commodities to your portfolio, because the annual costs of maintaining a derivative contract are far lower than the costs of holding $20m of gold bars under armed guard. The disadvantage of using derivatives is that these are short term instruments, and while managers will ‘roll over’ the funds into the next periods available contracts, this will incur fees and the differences in prices may result in the fund not accurately matching the long term gains or losses in actual spot prices.
What Commodity Funds Are Available?
There are a wide range of funds available to suit every commodity investors desire. I have compiled several lists below that attempt to summarise and list the different funds that currently operate for metals. This is not an exhaustive list, and these are not ‘recommendations’. Please read my disclaimer.
SpreadBetting & Contracts for Difference (CFDs)
Spreadbetting is a ‘retail-friendly’ way to place short term bets on commodity spot prices. This is substantially different to investing in a commodity for long term gains. In the short term, commodity markets react (and sometimes overreact) to the effects of demand and supply shocks. Therefore the reasons for placing short term trades will be short term in nature (Natural disasters, Terrorism, Political Climate, OPEC decisions), versus long term drivers such as population growth, improvements in production methods and heightened demand from emerging markets. Spreadbetting over the long term will produce various trading fees and potential losses from ‘rolling over’ bets into the next period. Spreadbetting will not form part of a long term investors strategy.
Equity of Mining & Extraction Companies
A traditional method of gaining exposure to the increase in the price of oil, for example, is to purchase the shares of oil companies of varying sizes. The profit margins of oil companies (especially those that deal with exploration and extraction) will be heavily effected by the market price of oil, and therefore ownership of equities in the relevant commodity sector can provide an imperfect but tradtional method of making a play on commodity prices.
The behavioural relationship between commodity spot prices and relevant equities is a complicated one. In some respects, ownership can provide leveraged returns compared to the share price. Think of a gold miner who can produce 1kg of gold for $1m and sell it for $1.5m, providing a net cash flow of $500k. If the market price of gold doubles, then the company can now sell it for $3m and produce $2m in profit – a quadruple increase in profit resulting from a doubling in the gold spot price. But to further complicate things, the effect on a stock price will be constrained if investors believe that the price spike is temporary, and they will refuse to incorporate the higher cash flows forever into their share price valuation.
Futhermore, ownership of the equity of a company exposes an investor to the specific risks of governance and mismanagement of the company. The gold price may increase over many decades, but unless the company secures new mining sites to exploit, its profits and share price will decline consequentially. For this reason, private investors should diversify across many companies in the commodity sectors to focus the exposure on the commodity price as much as possible.
Private Ownership of Commodities
Contrary to various ‘Myths About Gold‘, it is legal to hold gold in the US, UK and other developed nations (although I can’t speak for every nation). Gold bars weighing 1 troy ounce (31 g), and gold bullion coins are the standard method of holding gold privately. These can be stored in bank safety deposit boxes, or (if you’re brave) your own home. Due to their novelty and decorative value, the average private investor will only be able to buy gold bullion from providers at a premium above the actual gold spot price. This makes coins and bars quite an inefficient method of holding gold, but to many this disadvantage is outweighed by the security that a physical gold bar gives them.
The private ownership of commodities removes the counterparty risk associated with pooled investments. Counterparty risk is the risk of the person on the opposite side of your contract to default. Synthetic funds rely on the ‘other side’ of the derivatives contracts to stay solvent, and as the Madoff Ponzi Scheme showed, mutual fund assets are not always out of reach of the professional managers that we entrust as steward over our assets.
We explore 7 different method of investing in gold in ‘What is the Best Way to Hold Gold?‘. This demonstrates the often confusingly large number of routes into commodity investment!
When Should I Invest in Commodities?
As a largely ‘passive’ investor, I spend most of my time making sure that my portfolio utilises the science of diversification. I do not place reliance on the ability to ‘time the market’ and forsee where the markets are headed in the next 6 months. That said, in the equities markets you can use the overall Price/Earnings ratio to get a rough health check on the overall ‘expensiveness’ of stocks and get a rough idea of where we currently sit in the cycle. In the commodities markets there are no such barometers. This makes the task of ‘timing’ commodities extremely difficult. Commodities have no means of rational, technical valuation. Gold is simply as valuable as buyers perceive it to be at any given time. Commodities do not provide cash flows, nor do they multiply in volume. The price is merely a function of hundreds of microfactors existing at the current date. Some would say this makes timing your investment in commodities a fools game. I would be inclined to agree. If you are concerned about completely mistiming the market, then look into using the dollar cost averaging method of drip feeding your funds regularly into the market each month. To read more see ‘Are Commodities Overpriced?‘
What Percentage of A Portfolio Should Be in Commodities?
When talking about the rightful place of commodities in a risk-tolerant diversified portfolio, many experts suggest a figure of no more than 5%. This may strike you as being rather small, but I would remind you that commodities are perhaps the most volatile asset class you will ever hold within your portfolio. Just 5% in silver in April 2011 would have caused a 1.1% fall in the value of your total holdings. It may be helpful to think of commodities as a wild animal, which in small doses will jump all over the place (out of correlation with equities), helping to smooth returns. But in too large a quantity, it would wield so much influence over your profit & loss that you would suffer from risk drag – which is where excess volatility causes your actual returns to erode far below the average annual return.
The 5% allocation to commodities should be spread across a broad basket of commodities, making sure to capture precious metals, fossil fuels and agricultural commodities.
Related Commodity Articles @ Financial Expert
Are Commodities Overpriced? – A little fact, a little history and a little prudence guides our opinion on the valuation of commodities.
Commodities Spread Betting – A guide to one of the most adventurous and different methods of investment out there.
Are Commodities a Good and Safe Investment? – We look at the meaning of ‘safe’ and ‘good’ investments, while reflecting doubt upon the strength of commodities.
Commodities HYIPs – All Scams? An investigation into the opaque and often illegal world of commodity high yield investment programs.
Are Commodity Prices Affected by Recession? – What are the causal links between the economic and commodity cycle?
Commodities Trading – A look at the short term and speculative world of Commodity Trading.
Commodities News – My favourite source for the latest news on the commodities markets.
Is Gold Overvalued and Overpriced? – A question many are asking as gold reaches record highs. Will the gold bulls ever reget their decisions?
Guide to Investing in Gold Bullion Coins – Investing and pleasure can certainly mix in this traditional investing strategy dating back to Ancient Greece!
Common Myths about Gold – 4 frequent misconceptions held by new commodity investors.