Commodities are “dead money”, but that does not mean they cannot work for you. While it is true that the upside is limited – a bag of coffee beans will never grow into two – the costs of holding commodities can be significant depending on how you choose to invest in commodities. There are important reasons why Wall Street still sings their praises, and it isn’t just for the fees commodities brokers collect.
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Of course, you have to understand commodities and the ways in which you can invest in them before you can make the investments work for you. Here is what you need to know:
Commodities Do Not Move with Stocks, Necessarily
Commodities are not correlated with stock movements. While sometimes their movements sync, that is only incidental. For the most part, they exist in their own little world. Someone with a smaller portfolio may not need the level of diversification commodities provide, but by the time your portfolio size starts to equal more than your annual salary, commodity exposure can be very smart. In fact, according to the Journal of Investing, portfolio risk is “reduced significantly when 10% or more of the portfolio was allocated to commodity futures.”
Ways of Investing in Commodities
You have several options for how you invest in commodities, and each has its own unique relationship to the commodity in question. For instance, you can invest in the physical resource (this is usually done through futures), but you can also invest in the companies who mine the commodity or those who refine it. In this case, the changes in price tend to be exponentially different from the actual commodity. When the price of the commodity goes up, the price of mining stocks often rises even further because their cost of labor does not increase just because the value of the item they mine does. However, since a mining stock is still an equity, it is vulnerable in ways that commodities are not. According to Brian Hicks, portfolio manager of U.S. Global Investors’ Global Resources Fund, most investors would do well to hold physical commodities as well as stock in the companies that produce those resources.
When you buy a commodity futures contract, you agree to buy or sell the commodity at a set price on a set date. It is a financial obligation, but you can always sell your futures contract. You may also consider a managed futures account, which may regularly be adjusted to produce returns more similar to the actual commodity, but there are fees for that service. Another option is an investment in a commodity futures index. These are highly correlated with commodity spot indexes, but analysis of these investment vehicles is tricky. “Commodity futures indexes cannot use market-capitalization weighting (the rule most commonly used for traditional asset classes) because every futures contract has zero market capitalization,” explains Vanguard. “As a result, there is a lack of consensus on the best way to index commodity futures, and different providers use quite different indexing rules.”
Types of Commodities
Commodities are typically divided into two categories: soft and hard. Soft commodities are things that are grown or raised. This includes barley, coffee, corn, cattle, orange juice, sugar, and wool. There are also hard commodities. These are resources that have to be mined or extracted, such as copper, crude oil, and gold.
Soft commodities may be further divided into Agricultural Commodities (e.g. Corn, Wheat), Consumer Commodities (e.g. Coffee, Cotton), and Livestock Commodities (e.g. Live cattle). Soft commodities tend to be more volatile than hard commodities because they are affected by so many things. In addition to the natural growing cycle of the resources, there is also weather, spoilage, crop blight, livestock diseases, and other such issues that impact the integrity of the soft commodity. However, where there is volatility, there is also the potential for much larger rewards. For instance, in November 2013, there was a drought in Brazil, which is the largest producer of coffee in the world. Six months later, in May 2014, the price of Arabica beans had rose more than 80 percent.
Hard commodities are sometimes divided into Metal Commodities and Energy Commodities. In either case, they are a significant part of industrial processes and tend to dominate the commodities space. Hard Commodities are easier to handle and store, and they are less vulnerable to issues like the weather.
Commodities futures prices are recorded by the month. When you look at a Futures Price Table, you’ll see the price the commodity opened at for a given maturity month (e.g. May coffee, July coffee), the lowest and highest prices it has sold at for that month, the settle or settlement price (which is like a closing price but may vary), and the open interest or number of outstanding contracts for that month. Note that “the open or opening price is the price or range of prices for the day’s first trades, registered during the period designated as the opening of the market or the opening call,” explains the U.S. Commodity Futures Trading Commission. “Many publications print only a single price for the market open or close regardless of whether there was a range with trades at several prices.”
Understanding Commodity Contracts
Every commodity has its own contract value and margin requirements. The value of each contract is based on the market price at the time of issue. This is then multiplied by the value of the contract. Take coffee for example. Its contract size is 37,500 pounds. If it is priced at $1.30 per pound, the value of the contract is $48,750. However, commodities are generally traded on a margin of 10-20 percent. This means returns can be significant, but it also means that you could lose more than your initial investment or margin.
An investor is required to have an initial margin in his or her account, and the margin varies by commodity. Once this sum is deposited and the investor begins trading, he or she must keep a minimum balance in the trading account. If the account balance falls below the maintenance level, the investor receives a margin call, which requires him or her to add money to the account or have it closed.
Once trading starts, commodity prices have defined price movements called “ticks”. In the case of coffee, the tick size is $0.05 per pound or $18.75 per contract. Note that tick sizes are not standard and will vary depending on the commodity in question and that there is a maintenance margin rate to consider as well.
Commodities are not the best-understood investment, but that does not mean they are not a useful addition to your portfolio. In fact, if you understand how to use commodities and how commodity investments work, they are a good way to diversify your investments.