Investors basically have two choices when investing in commodities: 1) companies that mine, extract or farm commodities and/or 2) the price of the commodity itself in the futures markets. Both have advantages and disadvantages.
The futures markets allow investors or speculators to make or lose money based on the direction of a commodity. The term commodity in the futures markets can vary from US Treasury interest rates or currency rates to oil, corn, iron ore, etc. For purposes of this discussion, commodities will relate to non-financial commodities. Commodities trade on today’s price and prices on various dates in the future. Those prices in the future are sometimes lower or higher than today’s price. When it is higher, anybody invested in a passive commodity ETF can lose money even if today’s price is rising consistently. That is because the commodity ETF investments mature at $100 for example and the commodity has to invest into the future at a higher price of $103, let’s say, thus losing $3 from day one. This occurs even while today’s price is rising everyday. When the future prices are declining the ETF does not have this problem. However, don’t investors invest in commodity ETFs to make money when commodity prices are rising? There are active commodity ETFs which use blackbox strategies to solve this problem but investing with blackbox strategies creates a new set of problems. Hedge fund managers take advantage of the manadatory investments made by passive commodity ETFs each month, manipulating commodity prices to their benefit, which can be detrimental to the passive commodity ETF investor.
Companies who produce, farm, and extract commodities are generally publicly-traded companies where investors purchase their stock. Generally, if the current price of the commodity is increasing, the stock price will increase. However, there are other factors impacting the stock price such as the quality of earnings, the difference between the extraction/production price of the commodity versus the current price of the commodity, and the general interest in commodity companies. The risk for investors is that a 100% correlation does not exist between the increase in the value of the commodity and the increase in the price of the stock.
Since the late 1990′s large pension funds have been investing in passive commodity indices. This was due to a study by Goldman Sachs showing uncorrelated movements between commodity prices and stocks-the great diversifier( source: Index Investment and Financialization of Commodities; Ke Tang and Wei Xiong). Well, 20 years later everybody is doing this type of investing. The commodity futures markets are now being influenced by the “passive indexers.” Stock and commodity prices are now moving closer together. This is a bad diversifier.
Bottom line: Warren Buffet said investing in an investment that does not produce earnings or cashflow is speculative. Speculation is the hope somebody will pay more tomorrow for the same investment you purchased today without considering earnings or cash flow. Although commodities can provide value in a portfolio, as with any other type of investment, it is important to understand the level of risk involved.
Always Asking, Never Assuming™
Christopher Holtby