Hey there, time traveller!
This article was published 3/12/2010 (3178 days ago), so information in it may no longer be current.
As consumers, we all invest in some way in commodities. Be it gold, oil or soybeans, these are all items we buy and often use daily. Yet when it comes to buying these tangible assets as part of our investment portfolios, we often only own commodities indirectly. We own stock in companies that produce, process or handle commodities. Or even more indirectly, we own units of a mutual fund that owns stocks of companies that produce commodities.
In a sense, it's ironic that the very products we use every day, which we understand probably better than bonds, stocks or mutual funds, are a forgotten element for our investment portfolios.
Yet increasingly, we hear investment pundits talking about how our planet's finite natural resources will be increasingly valuable when measured against our seemingly infinite appetite to consume. Demand will inevitably drive up the price of many commodities, goes the argument, so it's best to catch a piece of the action.
So the question arises: How does one invest directly in commodities?
For the average investor, it's not a simple answer.
A good number of commodities — gold, silver, copper, oil, grains, cattle and gas, to name a few — are traded as futures contracts on exchanges.
"Futures are a more unique security that allows investors to benefit from commodity prices moving up or down," says David Derwin, an investment adviser with Union Securities in Winnipeg.
Essentially, a futures contract is an agreement between a buyer and seller of a contract. The seller agrees to deliver a commodity at a set price at a future date to the buyer of the contract. The pricing of the contract depends on the length of time it lasts and the current — or spot price — of the commodity.
While these contracts are traded today on exchanges, available for anyone with a few thousand dollars to purchase, futures contacts started out as a means for commodity producers and buyers to offset the risk associated with supply and demand.
"Futures contracts grew out of 'to arrive' contracts," says Harold Davis, a commodities researcher and author of Prairie Crop Charts, a weekly newsletter forecasting prices for specialty crops.
"About 130 years ago on the Prairies, farmers would harvest their crops all at the same time and all want to take them to the elevator at the same time."
But grain elevators couldn't handle all of the crops at once. As a result, operators would ask farmers to store their harvests and bring their product to the elevator at a later date.
"So the farmers said, 'If I'm going to take it home and store it for three months, what's the advantage for me to do that?' and they were told, 'Well, if you're going to be doing the storage and taking the risk, we'll pay you more than the current price.' "
Eventually, these contracts evolved into futures contracts traded on established commodities exchanges — including the Winnipeg Commodity Exchange — where producers of commodities could sell contracts for delivery of their product to protect themselves against falling prices.
And the buyer, a manufacturer dependent on that commodity, could buy the contract, locking in the cost to protect against price increases.
While futures came about from a need for price certainty, they quickly developed into a speculative market where investors could place bets on commodities' prices.
"A futures contract is effectively a bet on how much that underlying asset will increase in price," says Arvind Jain, an associate professor of international finance at John Molson School of Business at Concordia University in Montreal.
"If I think the price is going to go up, I am going to buy the futures contract, and if I think it's going to go down, I am going to sell the futures contract."
Today, in fact, the futures market has grown far beyond physical commodities, which now account for a small percentage of all traded contracts. Now an investor can buy a contract on an index, currency, stock or bond — even the weather.
And because so many contracts are held by investors and speculators, "most contracts are liquidated prior to or settled with cash instead of delivery of the actual goods," Derwin says.
"Originally, they were used for physical delivery, but in this day and age, that's not really their purpose."
Even producers and buyers of commodities rarely carry out a futures contract for delivery of the actual promised goods. An oil producer, for example, may enter into a futures contract to sell oil at a set price a year from now to protect against falling prices. But during that time, oil may rise well above the contract price. The producer will close out the contract and have to pay profits to the party on the other side of the contract. But any losses the producer incurred through the contract will be offset by profits from selling the oil at the higher market price.
Although these contracts are a risk-management tool for producers and manufacturers, futures are risky speculation for investors because they involve leverage. This means investors can purchase a contract worth several thousand dollars of a commodity for only a fraction of the cost.
"If it goes up, you have tremendous leverage and profit, but remember, if it goes up, it can also go down," Jain says.
"The way the futures contracts work is when you put down the margin — let's say the exchange says you have to put down a 10 per cent margin — and the price moves against you, part of the margin has been lost."
Effectively, the margin is a good-faith 'performance guarantee' on the contract, Davis says.
"Futures are a zero-sum game," he says.
One person on one side loses money from their margin and the other side gains an equal amount of money.
If the price of the underlying commodity keeps going against your side of the contract, you're then faced with a margin call.
"When your contract is trading for a loss, it stands to reason that you have to assure the other party that you are going to perform, and in that case, you have to put more money in," he says.
Basically, you have to pony up or close out the account.
Because only a fraction of the total worth of the contract is required to invest, speculative investors risk losing all or more of their margin investment, even with relatively small swings in price.
"Some contracts can be worth $100,000 to $200,000, so there's a lot of exposure," Derwin says. While you may only need $3,500 on margin for a contract worth $100,000 of oil, you risk losing all $3,500, if not more.
"It's definitely a complement to an already large portfolio," he says. "With smaller accounts, you're better off with an ETF that gives you the exposure, but with less leverage and risk."
Still, futures in and of themselves are not risky when used appropriately, such as for hedging, he says.
It's a bit like the saying guns don't kill people; people kill people.
But with a gun, at least the average person has some inkling what end of the weapon to hold when pulling the trigger, whereas with trading futures that isn't always so clear.
Correction from last week's article on income funds: A local investment adviser pointed out that fee-for-service advisers do not receive a fee from the mutual fund company when selling F-class funds. The article erroneously stated that they did.
Funds full of stuff
Exchange traded funds (ETFs) are basically low-fee mutual funds traded on stock exchanges. Many are index funds that emulate the price movement of an underlying index. A growing number of ETFs are based on commodities indices, such as gold, oil and silver. For instance, the Claymore Natural Gas Commodity ETF follows NGX Canadian Natural Gas Index. Finance professor Arvind Jain says ETFs are a low-cost, lower-risk alternative to investing in futures markets for investors, especially those with small investment accounts. "If you are wrong, you will lose a little bit of money, but you are not leveraged as much as you would be with a futures contract."
The golden exception to the rule
Unlike with many other commodities, investors have choices in how they can buy gold. They can own it through an ETF, a mutual fund, a futures contract, or they can go to their local financial institution or coin dealer to own physical gold. In some cases, the financial institution will hold the gold for investors, providing them with a certificate. But for investors wanting gold to have and to hold, they can do that, too, Jain says. "You can go to the bank and buy 10 ounces of gold and have it to keep you warm at night."
Futures... the good derivative
If futures contracts are a little like guns, then their prodigal cousin — over-the-counter (OTC) derivatives — are weapons of mass destruction. In fact, Warren Buffet famously called them WMDs a few years before they torpedoed the world's economy. Futures, however, are the more benign cousin, says commodities researcher Harold Davis. "These are derivatives that have the longest histories and are the most regulated and very visible," he says. "In the current environment and what happened with the meltdown a couple of years ago, there were no serious systematic problems with exchange-traded derivatives." The problem was with custom-made OTC derivative contracts between two private parties that involved losses that were not required to be valued (marked to market) daily like futures contracts traded on exchanges. "Dishonest or frightened traders could try to hide losses and their managers sometimes had very rude surprises," he says.
It's all a zero-sum game until someone loses billions
Because most derivatives are deals between two parties, there is always a winner and a loser. It's a zero-sum game. The losses of the loser are the gains of the winner. So when we think back to the 2008 meltdown, when AIG lost billions selling derivative 'insurance' on subprime mortgages, people on the other side of those deals gained just as much, Davis says. "In the entire discussion of derivatives losses in the 2008 financial meltdown, never once did they disclose who the winners were." The cruel irony is it wasn't really AIG and other losers on these trades paying up, it was the American taxpayer.
Winnipeg's commodity connection
The Winnipeg Commodity Exchange is more than 123 years old. Once located downtown, it is the leading canola futures contract exchange in the world. Now located on Pembina Highway, the exchange was sold in 2007 to Atlanta-based IntercontinentalExchange.