Saturday, February 2, 2013

What About Commodities?


What About Commodities?

A good friend recently asked me about investing in commodities.  While I ramble on about stocks and bonds, and occasionally mention real estate, I haven’t delved into commodities or currencies.  Why?  I’m an investor, which means that I’m relying on the ability of an asset to produce income over the long run.  When I invest in stocks, the idea is to own a small slice of the profits and ultimately, the dividends generated by a company.  When I invest in bonds, I’m relying on the borrower, a company, municipality, or consumer to produce enough income to pay interest and return my principal.  In fact, real estate is no different from stocks or bonds, except it is illiquid.  When I own property, it is the income from the rentals that creates value, and if I invest in a mortgage, it is income that pays interest and principal.

A commodity or currency isn’t income producing.  It’s merely a bet on a change in price and thus, it’s a speculation.  There’s nothing wrong with allocating some of capital towards commodities or currencies, but it’s really not long-term investing.  Perhaps you are savvy enough, or you know someone who is savvy enough to successfully trade commodities or currencies.  I’m not adept enough and don’t know anyone who can consistently gauge the direction of oil, metals, grains, or exchange rates.

Business Economics (2009)

Brokerage firms try to lure investors into commodities and currencies as an “uncorrelated source of return,” and indeed, the prices of these things do not appear to move in concert with stocks and bonds.  However, there are thousands of things in our economy whose price doesn’t move with stocks and bonds, but that doesn’t make them sound long-term investments.

If you think you have an insight into the future rate of inflation, then by all means allocate some capital to gold or another inflation-sensitive commodity.  Or, if you have a strong view of the Euro, Yen, or Swiss Franc, go ahead and make a bet.  However, you’re going to find that putting on these trades is expensive.  Moreover you shouldn’t forget that you’ll also have to know when to remove the bet.  I’ve known all too many commodity hedge funds that produced spectacular returns for two or three years and then watched the profits melt away in a couple of quarters.  For example, they had a keen insight into rising oil prices, but didn’t see the subsequent collapse in petroleum markets.

If you don’t have the minimum required to invest in a hedge fund that specializes in commodities or currencies, there are a bunch of mutual funds and ETFs that can easily get you into commodities.  If it’s gold you’re after, there are funds and ETFs that are actual investments in the underlying commodity, such as the SPDR Gold Trust (NYSE: GLD).  However, most strategies involve buying and periodically rolling over futures contracts, as it is difficult to actually own the commodity for any meaningful period of time.  The futures strategy won’t precisely track the cash price for commodities or currencies because the futures price is rarely the same as the cash price.  You’ll pay 0.60% to 0.75% in management fees per year for the privilege, plus the trading costs of having the manager roll the contracts as they expire over time. 

Wall Street, being infinitely creative, has created ETNs or exchange traded notes, which are simply credit instruments that promise to provide you with the return of a credit index.  While the ETN eliminates the problem of rolling futures contracts, it subjects you to the credit risk of whomever entity issued the note.  In other words, the counterparty has to be able to come up with the your principal and profit when you decide to sell.  As always, it will cost you 0.75% to 1.0% in fees to make these types of investments, and some of these products have additional fees buried in the details.

If none of these choices appeal to you, Wall Street offers sector mutual funds or sector ETFs that give you equity ownership in companies that mine or produce various commodities.  While the price of the underlying commodity will undoubtedly influence the price of the stock, there are lots of other factors that could make the sector fund or ETF move in a direction different from the underlying commodity.

Some people like to trade stocks or play around with options with 5% of their money.  They set aside a sum of money that they can stand to lose and trade up a storm.  If you decide to plunge into commodities or currencies, those investments should be made within the confines of that 5% bucket and shouldn’t be attempted with your serious money.

1 comment:

  1. The prices of precious metals are dropping everyday. But investment in commodities is one of the best investment where you can make profit in short time. Always get in touch with financial experts so that you can minimize the loss of risk.

    Regards
    Intraday Tips India

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