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  • Writer's pictureOwen

How to invest in Commodities, and whether you should.

When it comes to investing, some people can get caught up the news cycle. Right now that is the Euro mess, the US fiscal cliff and Apple talk. 


While it can be fun to discuss, it can also be misleading and cause you to miss opportunities.  Not all investments are equities and bonds. Commodities can be a potential holding as well for the more sophisticated investor.


Uncorrelated returns are always a good idea for a portfolio, yet difficult to achieve. Commodities is one of the few places where it can be possible.


As Jim Rogers has said, “Commodities tend to zig when equity markets zag.”  So how can someone invest in commodities whilst limiting their risk.

 

What is a Commodity:

This usually refers to un-differentiated products, like wheat, cotton but also elements that are mined liked copper, silver and iron. Before you


Considerations:

  • Seasons:  Each commodity can have different rhythm and in the case of soft commodities, they will have seasons. You should know when each season starts and ends.  Often times there is a big run up or drop down in price depending on the planting estimates.  It is best to sit on your hands until you have enough information and a good entry point.

  • Price:  By looking at charts, you can see the current and historical price levels of certain commodities.  Be careful buying too high and if price is dropping wait for it to stabilize.  This website gives up to date quotes on all soft commodities. Below is a chart for Sugar, as you can see price has leveled off around $19 which might signal an opportunity to buy.

  • Market conditions:  It is important to stay up to date on supply and demand reports as they are released.  The USDA website provides excellent information on the world markets.

  • Weather:  If you have a knack for predicting weather, then this might be perfect for you.  Obviously, watching weather patterns and how they affect crops is important.  A good example is the drought in North America last summer where there were initial reports of hot weather and it never let up.  This resulted in Corn and Soybean prices skyrocketing.  If an investor got in after reading the initial reports, he could have done quite well.

  • Research:  As it goes with any investment, you should know what you are buying inside and out.  Use Google and agriculture websites frequently to find information.  Also, it could help by talking to farmers or seed suppliers to determine which direction the market is going.


If you aren't willing to do the research or work, or your current job doesn't provide you with a strong insight into a particular commodity, then investing in this sector might not be for you.


Aren’t they risky? Yes, but less than before.


Commodities aren't for everyone. They certainly aren't for the buy and hold traditional investor. You will need to pay attention to markets and trends. Still, recent developments have reduced the risk and improved accessibility to average investors.


Traditionally, buying commodities meant trading futures, with all the leverage and potential for loss that implies.   These days ETNs (see section below) reduce that much of that risk, although they do include a risk of their own.


The key to commodities: Understanding the cycle and drivers.


A commodity can be stable but can also suddenly turn volatile, but it does ultimately have a firm floor.   No commodity like wheat or copper can fall to zero.  An individual share or company can.  If wheat falls then farmers switch to other crops or to producing other things (like grazing cattle).  


Supply can, in many circumstances react pretty quickly, both in removing excess supply when prices are low and adding supply when prices are high.


In soft commodities, the cycle depends on the crop.  Tree-based crops like coffee or cocoa have more lags on the way up and down due to the time it takes to get trees producing and also due to the cost of removing supply. Annuals like wheat, corn, sugar and soy however can respond quicker.  If you are patient and wait until you’re the particularly commodity is at a year or multi-year low, then much of the risk has been removed from your investment.


Buying a commodity via an ETN.


If you want to directly invest in commodities, traditionally there was only one way to invest (futures contracts), but things are changing so you no longer need to trade and understand derivatives.


Use an Exchange Traded Note (ETN – a relative of an ETF) that tracks the future contract or buy the future contract directly itself.  I prefer using ETN’s as they are cheap and above all, easy to use.  Buying futures contracts requires a futures account and is quite complicated. It is quite possible to buy a derivative contract that falls to zero or beyond. That's a level of risk that isn't worth it for most investors. 


When buying ETNS make sure:

  • You understand your strategy in buying.

  • Do use limit orders as there could be a wide big/ask and market orders could get filled at a bad price.  This applies to both buying and selling your ETN.

  • What your exit price will be for a profit. Commodities are not buy and hold investments since prices tend to have various peaks and valleys it doesn’t make a good long term investment. 

  • You understand your potential tax situation since for Americans and some others you might be hit with tax on your capital gains of either short or long term.


Costs and Risks of ETNs


An ETN is not an ETF or a stock. Different risks apply here.

Because an ETN is issued by a provider, and inside the structure the provider will be buying and selling derivative contracts to produce the return listed on the wrapper.


You'll need to understand a few risks.

  • An ETN is subject to credit risk of the provider. In other words, if the bank who issues the note goes bankrupt, then your note will likely also fold.

  • ETNs might not match the commodity well. Tracking error or in other words, failing to rise alongside the commodity, can be a problem.

  • The roll costs of derivative contracts inside ETNs, as well as some kinds of ETFs, can also eat into returns. This is modest in the short term, but really builds up over time and is a big reason


Overall, if used correctly an investment in commodities can be a strong weapon to add to your arsenal. Uncorrelated returns are truly hard to find. ETNs make commodities more accessible and reduce the risk, but you still need to understand and purely based on supply and demand makes it less susceptible to media attacks that most stocks are. They do have some good volatility that if timed right can reap strong returns.


Disclaimer before you invest.


Commodities are NOT for most average investors. This post does not recommend them for average investors and they are far from a guaranteed investment. This post is general in nature and does not constitute personalized advice. All investors should speak to a qualified investment adviser about their personal situation before taking investment decisions.

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