Evan R. Guido
Commodities are physical substances that are fundamental to the creation of other products or to commerce
generally. Unlike most other products that are bought and sold, one commodity is basically indistinguishable from any
other commodity in the same category. Though there may be various grades of a given commodity that indicate its
quality, those grades are standard across producers; one company's light sweet crude oil is essentially the same as
another's light sweet crude.
Examples of commodities include:
- Oil
- Natural gas
- Agricultural products such as corn, wheat, and soybeans
- Livestock such as cattle and hogs
- Timber
- Metals such as copper, nickel, and zinc
- Precious metals such as gold, silver and platinum
Because of their role in the creation of other goods and services, commodities are essential to the global economy. A commodity’s availability can be affected by many factors. The weather, the economy, foreign exchange rates or political conditions can lead to shortages; overproduction and economic slowdowns can lead to an oversupply.
Because supply and demand is such a strong factor in determining commodity prices, those prices can fluctuate wildly. In turn, changing prices can affect the prices of anything that depends on them. For example, when oil prices rise, companies that depend on oil for everything from raw materials to transportation of their finished products often pass along their increased costs to their customers.
Why are commodities an alternative asset class?
As with most investments that are considered alternative asset classes, commodities may behave very differently from stocks or bonds and can help provide additional balance to an investment portfolio. For example, if corporate profits are suffering from high oil prices, oil-related investments might help offset any negative impact on the stock portion of your portfolio.
Also, most individual investors have no desire or ability to invest directly in commodities; how many people want to take delivery of tons of grain or barrels of oil? That means that the biggest market for commodity investments traditionally has been not individual investors but either companies that need a given commodity in their business, or sophisticated institutional investors and full-time commodities traders. However, in recent years, new ways of investing have been created to give individual investors greater access to commodities as an asset class rather than as physical assets.
The two commodities markets
Commodity investments generally take one of two general forms: buying via the spot market and buying commodity futures. The spot market involves a cash contract to buy and take delivery of the physical asset within a specified time; for example, a breadmaking company would purchase a certain amount of flour to make its products.
The futures market involves contracts for future delivery of a commodity at a specified price on a given date. Futures contracts give businesses a way to try to lock in a favorable price for a needed commodity. However, commodity futures contracts also are traded as investments in and of themselves; the buyer is speculating on price movements in the underlying commodity and hopes to profit from the contract itself.
Commodity futures trading is done through one of the major commodities exchanges around the world. Key U.S. commodities exchanges include the New York Board of Trade, the Chicago Board of Trade, the New York Mercantile Exchange, and the Chicago Mercantile Exchange.
Commodity investors typically invest in either futures contracts or through one of the many investment vehicles that use indexes of futures contracts.
Why do people invest in commodities?
Individuals typically invest in commodities for one of 2 reasons. Either they want an investment that has little correlation with their existing portfolio, or they believe they understand the market for a given commodity and are able to spot what they believe are opportunities for speculative profits.
Advantages
- As noted above, various commodities may have little correlation with more mainstream investments such as stocks and bonds; the risks involved with commodities may be very different from the risks of stocks and bonds. Investing a portion of one's portfolio in commodities-related investments can provide greater diversification, though diversification alone does not guarantee a profit or insure against a loss.
- Commodities can be a good inflation hedge. When costs are going up, often it's because costs of everyday items are being pushed up by rising commodity prices. Inflation is caused by high demand for goods that are in limited supply, and often the goods that are in limited supply are commodities.
- Some commodities, such as industrial metals, can provide an investor with indirect exposure to global growth and emerging economies that need commodities in order to build and develop.
- A well-timed investment in a specific commodity can be extremely profitable if the commodity is suddenly in great demand and prices rise.
- Commodity futures contracts can be bought and sold on margin, and initial margin requirements for unhedged positions can be as little as 20 percent, much lower than the 50 percent initial margin ordinarily required for stocks. However, margin also involves its own risks (see Tradeoffs, below). Commodity index futures (see below) also can be shorted if you believe the commodities markets will fall.
Tradeoffs
- Commodities can be highly volatile investments. Depending on the commodity, prices can be affected by many factors outside an individual producer's control. As a result, commodities probably are not suitable for the bulk of your portfolio, and may not be suitable for all investors in any case.
- Lower margin requirements for commodities futures contracts mean that if your commodities investment goes bad, you risk a much greater loss. You could not only lose your entire investment but a great deal more if your investment is highly leveraged, and the volatility of the commodities markets increases that risk. Also, a change in the margin requirement for a given commodity can affect its price.
- Depending on the vehicle used to invest in commodities, fees and commissions can be high.
- Investment in commodities, especially a single type of commodity, may require a level of expertise in that particular market that many investors lack. Commodities markets are notoriously speculative, and the price of a commodity is extremely vulnerable if the market for that commodity suddenly drops, so familiarity with the dynamics of trading in a specific commodity is important before investing. Even experienced investors can have difficulty; investments in natural gas that went bad were a major factor in the 2006 downfall of the hedge fund Amaranth Advisors.
- Natural resources such as mines and oil deposits eventually can run out of the commodities they produce, reducing or eliminating the value of your investment.
Types of commodities
Investing in oil/gas
Energy is one of the most crucial commodities in the world's economy, and the image of someone who strikes it rich by discovering oil is ingrained in the American psyche. However, energy investments are a classic case of high risk/high potential reward. Even if an energy investment pans out, the market for oil and natural gas can be extremely volatile because it is so dependent on supply and demand, which can vary dramatically with weather conditions-- think about the impact of Hurricane Katrina or an unusually warm winter-- as well as the political and economic climate.
New oil finds or new technology for extracting oil or gas also can affect the value of an energy investment. Energy investments can help you hedge against the impact of inflation on your portfolio. When the cost of goods and services are rising, rising energy costs are often part of the reason. That allows the energy portion of your portfolio to help balance any negative impact on stocks or bonds.
In deciding on an energy investment, think about whether you are interested in the potential rewards and risks of exploring for profitable oil or gas resources, or prefer to focus on ongoing income. That orientation can help determine the way in which you choose to invest in energy. Depending on the vehicle you use for your energy investments, oil and natural gas investments can provide tax benefits. For example, oil and gas limited partnerships may provide significant up-front deductions for drilling and exploration expenses, and some potential for sheltering taxes. However, investments with a demonstrated history of producing income might be more suitable for some investors. Some ways of investing in energy-- for example, futures contracts-- are strongly affected by price fluctuations; others, such as independent drilling companies, are more dependent on other factors like their success or lack thereof at discovering and producing oil.
Because of the high risk/high potential reward of many oil and gas investments, there are many scam artists pitching fraudulent schemes. Thorough investigation of any potential energy investment is essential before putting money into it. You should be especially cautious about any energy investment promoted over the phone by a stranger or via an unsolicited fax, or that promises "guaranteed high profits." The SEC has some useful tips for investigating oil and gas investments at www.sec.gov.
Investing in agricultural products
Futures contracts for a variety of soft commodities (coffee, cotton, sugar, cocoa, orange juice), grains (corn, wheat, soybeans) are traded on exchanges around the world. Soft commodities as well as livestock such as cattle and hogs are perhaps the most vulnerable commodities to the effects of weather; a bad planting season, a lack of rainfall, or a natural disaster can be devastating. A surplus or shortage can mean short, sharp price swings in either direction, and in the case of a shortage, it can take some time for supply to catch up with demand. Those price swings are one of the reasons that futures contracts play such an important role in trading of soft commodities; they enable businesses that depend on those commodities to better forecast their costs.
Investing in metals
Gold and other precious metals such as silver technically also are considered commodities. They are the only commodities that are really feasible for most investors to own as hard assets, in the form of bullion or coins. Other metals, such as copper, nickel, and zinc, are used as building and industrial materials.
Investing in timber
Timber and timberland has the advantage of being able to profit in a variety of ways. Timber is not only basic to the paper and construction industries, but it has the advantage of being a renewable resource. Trees grow at a predictable rate, which helps give some stability to this particular commodity, and managers have some flexibility in how and when they harvest the timber to maximize profits. In some cases, timberland investments can be converted into real estate holdings. And as with most commodities, returns on timber investments are not highly correlated with the stock or bond markets, making them a useful way to diversify a portfolio.
However, forest fires and damage from pests present two major risks to timber investments. Also, paper and construction are both notoriously cyclical industries, which in turn affects the timber industry. Finally, direct investment in timber can be expensive and involve high initial investments.
Ways to invest in commodities
As noted above, the storage and transportation challenges involved with most physical commodities has led to the development of many financial products that can give investors exposure to commodities as an asset class without requiring them to actually take delivery of, say, orange juice, or oil.
Among the ways you can add commodities to your portfolio are:
Commodity futures/Commodity index futures
Futures contracts are one of the primary vehicles for investing in commodities. An individual commodity futures contract is a legally binding agreement to buy or sell a given commodity at a certain date at the price specified in the contract. However, most futures contracts are closed out before the date specified. The size of a commodity futures contract varies depending on the commodity. An oil futures contract typically is for 1,000 barrels of oil; for corn or soybeans, a contract is for 5,000 bushels.
There also are mini-futures contracts for crude oil, heating oil, gasoline, natural gas as well as some agricultural products, gold and silver. The mini-contracts are much smaller-- anywhere from one-fifth to half the size of a regular contract-- with correspondingly smaller margin requirements. However, they may have less liquidity than full-sized contracts.
Before investing in futures, you should understand fully how the futures market works and all the risks involved. Investors may lose the entire amount of invested principal in a relatively short amount of time. Options and futures are not suitable for all investors.
In addition to trading in futures contracts for a given commodity, you can also invest in commodity index futures. A given commodities index, such as the long-standing Reuters Jefferies CRB Index, may track multiple commodities, and you should understand how the various commodities are weighted within the index. A commodities index futures contract allows you to invest in a variety of commodity futures more easily than buying all of the individual futures contracts themselves.
Both commodity futures contracts and commodity index futures can be traded on margin in a commodity futures account. You also can buy or sell put and call options on both.
Commodity futures trading involves a high degree of risk and is not suitable for all investors. Investing in commodity futures involves forecasting not only the direction of market changes, but the magnitude and timing of those changes. Before investing in a commodity futures contract, make sure you understand not only the process of investing in futures, but the commodity market in which you are trading. Remember that when you invest in commodities futures, many of your fellow investors are full-time commodities traders buying on behalf of businesses that use the commodities as part of their product.
Commodity index mutual funds and exchange-traded funds (ETFs)
As you might expect, the various commodity indexes have given rise to mutual funds and exchange-traded funds that invest based on those indexes. A commodity index fund may attempt to replicate the performance of a broad-based commodities index, such as the Goldman Sachs Commodity Index (GSCI). Or it may focus on a specific type of commodity, such as gold or oil. To replicate their index, funds often invest in derivatives based on the index.
However, in some cases, an ETF is based on the actual commodity itself rather than on futures or derivatives. For example, shares in one popular gold ETF represent shares of a trust that holds actual gold bullion, and the fund's expenses are paid out of the value of that bullion. Other funds may hold commodity futures. Like other ETFs, commodity ETFs can be traded throughout the day, bought on margin, and sold short.
If you're considering a commodity mutual fund or ETF, be sure to check out how the fund pays out income. Whether that income is distributed as ordinary income or capital gains can affect your tax consequences. Also, whether the fund holds gold or silver bullion may affect whether its returns are taxed as collectibles, which are taxed at 28 percent. Before investing in a mutual fund or ETF, carefully consider its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Obtain and read a fund's prospectus before investing.
Royalty trusts
In some cases, energy companies sell the right to ongoing income from their assets to a legal entity known as a royalty trust or income trust. The royalty trust then distributes those profits as royalties to the trust's unitholders. The trust may be traded just as a stock is.
Royalty trusts are attractive to income-oriented investors. Because trusts are required to pay out their cash flow as dividends, they typically pay a relatively high yield, usually monthly or quarterly. However, the yield is by no means guaranteed; it will fluctuate with the price of the oil or gas that provides the trust's income, as will the value of your investment in the trust.
The trust pays no corporate income tax, so there is no double taxation of dividends as there is with corporate dividends. The trust passes along a proportionate share of its depreciation and depletion allowances to unitholders, who do not have to pay taxes on that portion of their distribution until the units are sold.
U.S.-based royalty trusts are prohibited from adding to their assets. As their energy reserves become exhausted, distributions will begin to drop and eventually disappear, though that might not happen for many years. However, there is no such prohibition for royalty trusts that trade on U.S. exchanges but are based in Canada. Canadian energy trusts routinely buy additional resources to replenish fields that are beginning to run dry. (Canadian trusts also will no longer be exempt from corporate income taxes beginning in 2011).
Unlike a master limited partnership (MLP), a royalty trust has no general partner; all units are equal.
Master limited partnerships (MLPs)
A master limited partnership is similar to a royalty trust in providing an ongoing stream of income from energy-related operations. However, the two are structured differently. A MLP has a general partner that runs the business and assumes all liability for it; all other investors are considered limited partners.
Shares of a publicly traded MLP are considered corporations for tax purposes (unlike private limited partnerships). In the past they were popular as tax shelters for ordinary income; however, the Tax Reform Act of 1986 drastically curtailed that ability.
Exchange-traded notes (ETNs)/structured products
In some cases, financial institutions have developed derivatives and debt instruments that are traded like equities but whose returns are linked to the rise and fall of a commodity's price. A structured note is linked to the performance of a commodity index.
About Evan:
Evan heads a wealth management team at Baird in Sarasota, FL focused on retirement
planning. Evan entered the investment business in 2002. His team holds a series of
educational workshops in the community and is involved with numerous clubs and
charitable organizations in the community. Evan was born in St. Petersburg Florida,
attended the University of Alaska Anchorage and has 3 beautiful children with his wife
Brittany.
Evan Guido is a Financial Advisor with Robert W. Baird & Co. The content of this article was produced and provided by Broadridge Investor Communication Solutions, Inc. Copyright 2015. Baird does not offer tax or legal advice.
Evan R. Guido
Director, The Evan Guido Group, Retirement Planning & Portfolio Management
One Sarasota Tower, Suite 1200
Two North Tamiami Trail
Sarasota, FL 34236-4702
941-906-2829 Direct Line
888 366-6603 Toll Free
941 366-6193 Fax
EVANGUIDOGROUP.com
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