Commodities

There are ways of making money in commodities. But buying into a commodity fund - or any other investment in commodities that is open to the private investor - is not one of them.


'Commodities' means basic raw materials like gold, copper, sugar, cattle. To be of any financial interest they must be easily tradeable.

There are three things you can do with commodities:

  • Buy the physical product, take delivery of it, store it, and then either consume it or sell it - arranging for delivery to the buyer according to agreed instructions. This is called dealing in 'physicals'.
  • Make a forward contract to buy (or sell) the product some time in the future. Later you may either take (or make) delivery or get out of your contract by selling it to someone else
  • Trade in futures contracts on a futures market.

As a small private investor your only way of investing in a commodity is to buy a commodities fund. A commodities fund may be doing any or all of the above.

Returns

An average equity share will make money over the long term because that's what the company is trying to do. An average cash deposit will earn interest. But all a commodity does is sit there. It does not produce income. So an investment in commodities is paddling upstream.

It's worse. Commodities cost money to keep. These costs are called holding charges - storage, finance, insurance and wastage/ depreciation.

Then there are the management charges. Any form of private investor exposure to commodities will incur them, and they will be steep.

So a commodities fund has to work very hard trading in forwards and futures to make more money than the average share. In choosing to invest in commodities instead of equities you are betting against the odds. Or backing your judgement. Good luck

So why do we read of people making fortunes in commodities?

Because of:

  •  leverage. Commodity contracts usually operate on margin. Only a small proportion of the contract value need be put up in cash, which magnifies both profits and losses.
  • 'survivorship bias', which clears out the losers.
  • the journalistic habit of 'picking peaks'. See Data Biases.
  • the often corrupt relationships between the rulers of commodity-rich countries, their intermediaries and the legitimate businesses of the the developed world.

Gold

Gold is special because of its place in the monetary system. It has its place as a hedge against currency debasement. It may occasionally be right for individuals to invest in it. But only under the direction of a good investment adviser.

Controls

Really it is unfair to put this warning under 'Commodities' because it applies to all investment products that are a little out of the ordinary. But the dependence of commodity funds on futures trading makes these questions particularly relevant.

What do you know about:

  • the regulations under which the fund operates, and the compensation available to the private investor for fraud or misfeasance?
  • the fund's internal dealing controls that ensure that trades are placed in the correct accounts? Remember that trades a few minutes apart can be at different prices, so you do not want any hanky panky between your account and the House's trading for its own account
  • your fund's trading risk limits (if any)?
  • the financial strength of your trading house and the financial consequences for you of its collapse?