Investing in Commodities - Outside View by Asad Dossani

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Investing in Commodities
Sep 13, 2010

In recent years, commodities have taken a greater role within individual's portfolios. Many investors now wish to hold commodities in addition to their stock portfolios. The easiest way to do this is through the use of Exchange Traded Funds (ETF). ETFs will track the price of a commodity and provide the investor with that return minus the fund's expenses.

On the NSE, there are a variety of gold ETFs once can invest in, but unfortunately not much else when it comes to commodity ETFs. To successfully invest in commodities, it is important to have a diversified portfolio that includes metals, energies, and agriculturals.

The only other way for individuals to invest in commodities is through the use of futures. The Multi Commodity Exchange (MCX) provides futures in a variety of commodities such as gold, silver, crude oil, natural gas, and many others. Using futures to make investments in commodities is a bit more effort than using ETFs alone, but is straightforward nonetheless.

A commodity ETF will usually work in one of two ways. They will hold the physical commodity - in which case it will track the returns of the spot price. The fund will then have expenses related to holding the commodity such as insurance and storage costs. Alternatively, the ETF will hold futures on the commodity. The expenses will be related to transaction costs of purchasing the futures, and then rolling the futures each month upon expiry. An ETF will use futures when the commodities are perishable (such as agriculturals) or expensive to store (such as crude oil).

If we want to invest in commodities without ETFs we can essentially replicate what the ETFs do. As holding the physical commodity is not practical for retail investors, the obvious method is through the use of futures.

When it comes to investing in commodities using futures, here are a few things to keep in mind. As we know, futures offer leverage. Investors only need to put up a fraction of the contract's value to get exposure to the commodity. If you use an ETF, you have to put up the full amount. If using futures to invest for the long term, it is advisable to set aside the full value of the contract (as if we were buying an ETF). This will ensure there are no margin calls, and that risk is minimized. Putting up the full amount ensures that the percentage return we get on our funds is equal to the performance of the commodity.

Of course, if one wishes to use leverage to increase percentage return, that is possible too. In fact, we can usually using some leverage and still invest for the long term. If we put up half the value of the contract instead of the full amount (leverage ratio of 2:1), the commodity would have to fall 50% before we'd have to close the position. It's pretty safe to assume most commodities won't fall that amount in any given year.

The second point to remember is that futures expire. Holding futures for long periods requires that we continually roll the contract when expiry is nearing. Our overall return will then depend not only on the movement of the underlying commodity's spot price, but also the term structure of futures prices. If futures prices are significantly higher than spot prices, our return will be reduced because we have to enter into new contracts at continually higher prices. There reverse is possible too, if futures prices are lower than spot prices, our returns will be increased.

Investing in commodities using futures will usually have somewhat higher costs than using an ETF. This is because the transaction costs of the ETF can be spread across many more investors, resulting in lower costs for each investor. Until ETFs for other commodities are available, investors will need to use futures to gain exposure to commodities.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

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1 Responses to "Investing in Commodities"

P.S.SATHYAMURTHY

Oct 28, 2010

an excellent primer on commodities. However, pls. clarify on the tax treatment capital gains for short term and long term so that i can start investing.
pssathyamurthy

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