Why Invest In Commodities?
Now it's time for the big question: Why invest in commodities at all?
A brief answer to this question is that based on historical data, adding commodities exposure will increase your returns while lowering your risk.
Well, to understand that, we first have to talk about the single most important topic in investing: asset allocation.
It's The Markets That Matter
Most investment advice you read in the paper is focused on picking stocks. We fret about it; we watch Jim Cramer on CNBC; we read the Barron's roundtable issues. An entire industry has built itself around picking stocks.
But the data show that picking stocks doesn't actually have much of an impact on your portfolio's performance, as long as you make reasonable choices. What really matters is what markets you pick, not what stocks you choose. Brinson, Hood and Beebower wrote the seminal study on this in the year 1986: Determinants of Portfolio Performance. The authors examined the quarterly performance of pension funds and found that how these funds invested among different markets accounted for 94%% of their performance, leaving just 2%% left over for when (market timing) and 4 % for what (security selection).
In other words, the pension's "asset allocation" decisions were the key to its returns.
What Is Asset Allocation?
Asset allocation is how you invest your portfolio in different parts of the market: cash, stocks, bonds, commodities, real estate and more.
Asset allocation is important because each of these "assets" tends to perform in a certain way: Some are volatile; others are not volatile; some rise when the economy does well; others are countercyclical and so on.
The goal with a smart asset allocation plan is to build a portfolio that fits your ability to accept risk and meets your needs for expected returns.
Consciously or not, you have already made a lot of asset allocation decisions. Some small portion of your wealth is probably in cash: bank deposits, money market mutual funds etc. A much larger portion is probably invested in your house: real estate. And then you have what you think of as your portfolio: a collection of stocks, mutual funds, bonds and maybe, just maybe commodities.
Correlations: The Real Reason for Commodities
One goal of a smart asset allocation plan is to create a diversified portfolio. That way, if part of your portfolio hits a rough patch, the other part may perform well. For this reason, it's important to make sure your different assets are well different.
When two things move in sync, it's called correlation. A correlation of 1.0 means that two things move in lockstep: An elevator going down and the person riding inside are perfectly correlated. A correlation of zero means there is no rhyme or reason to the comparison at all. An elevator going down and someone sitting in the lobby reading a paper are uncorrelated. A -1.0 correlation means two things move in opposite directions: An elevator and its counterweight are negatively correlated.
When we pick asset classes, we generally want them to be as uncorrelated as possible. If our stock fund and our bond fund go up and down at the same time, we've gained nothing but another line on our statement.
In general, bonds are only minimally correlated with stocks, which is one of the reasons people like having them in their portfolio. But commodities (and particularly commodity futures) have actually been negatively correlated to both stocks and bonds historically, as illustrated in the paper Facts and Fantasies About Commodity Futures by Gary Gorton and K. Geert Rouwenhorst. In other words, when stocks and bonds head south, commodities tend to head north. Commodities are the only asset class that is negatively correlated to bonds, making them a powerful tool for diversification.
Commodity market refers to physical or virtual transactions of buying and selling involving raw or primary commodities. A soft commodity generally refers to commodities harvested as products such as wheat, coffee, cocoa, sugar, corn, wheat, soybean and fruit traded in the commodity market. Hard commodities usually refer to commodities that are extracted such as (gold, rubber, oil).While commodities may be grouped for regulation purposes and more, in large classes such as energy, agricultural including livestock, precious metals, industrial metals, other commodity markets, these are broken down into about a hundred primary commodities (soybean oil, recycled steel). Investors access about 50 major commodity markets worldwide uses growing numbers of exchanges with virtual transactions increasingly replacing physical trades.
A financial derivative in the commodity market is a financial instrument whose value is derived from a commodity as item or underlier. Derivatives’ trading employs various techniques to increase profit and manage risk. Derivatives in the commodity market are assets that are either exchange-traded derivatives or over-the-counter (OTC) derivatives. With the increased diversity and complexity of commodities derivatives, new international institutions have emerged, such as clearing houses some with Central Counterparty Clearing, which provide clearing and settlement services on a futures exchange, as well as off-exchange in the over-the-counter (OTC) market.
A exchange-traded commodity (ETC) is a commodity for which spot (cash) and futures markets are established and where official or settlement prices can be determined. Exchange-traded commodities include: wheat, corn, soybeans, oats, live cattle, cocoa, frozen orange juice, sugar, gold, silver, coal, electricity, gasoline, crude oil, diesel, ethanol and more.
Conversely, a non-exchange-traded commodity is a commodity for which spot and futures markets do not exist and the only price information available comes from data provided by producers, consumers and traders. Non-exchange-traded commodities include: fresh flowers, melons, lemons, tomatoes, grapes, eggs, potatoes, asphalt, arsenic, borax, gypsum, asbestos, cement, carbon dioxide, rare earth metals, magnesium, manganese, silicon, rhodium and so on.
In fact, most commodities are not traded in exchanges. Only the major ones are traded.
Commodity Price Index
A commodity price index is a fixed-weight index or (weighted) average of selected commodity prices, which may be based on spot or futures prices. It is designed to be representative of the broad commodity asset class or a specific subset of commodities, such as energy or metals. It is an index that tracks a basket of commodities to measure their performance. These indexes are often traded on exchanges, allowing investors to gain easier access to commodities without having to enter the futures market. The value of these indexes fluctuates based on their underlying commodities, and this value can be traded on an exchange in much the same way as stock index futures.
The constituents in a commodity price index can be broadly grouped into the following categories:
- Energy (such as Coal, Crude Oil, Ethanol, Gas Oil, Gasoline, Heating Oil, Natural Gas, Propane)
- Base Metals (such as Lead, Zinc, Nickel, Copper)
- Precious Metals (such as Gold, Silver, Platinum, Palladium)
- Grains (such as Cocoa, Corn, Oats, Rice, Soybeans, Wheat)
- Softs (such as Butter, Cotton, Milk, Orange Juice)
- Livestock (such as Hogs, Live Cattle, Pork Bellies, Feeder Cattle)
Investors can choose to obtain a passive exposure to these commodity price indices through a total return swap. The advantages of a passive commodity index exposure include negative correlation with other asset classes such as equities and bonds, as well as protection against inflation. The disadvantages include a negative roll yield due to contango in certain commodities, although this can be reduced by active management techniques, such as reducing the weights of certain constituents (for examples precious and base metals) in the index.
Cash commodities or actuals refer to the actual physical commodity for example, (wheat, corn, soybeans, crude oil, gold and silver) that someone is buying/selling/trading as distinguished from derivatives.
Electronic Commodities Trading
Electronic commodities trading had advanced from dealers using their computers to make transactions to computer determined trading with computers buying and selling without human dealer intermediation through the alternative trading system (ATS). By 2011 high frequency traders (HFT) algorithmic trading, had already almost phased out "dinosaur floor-traders".
Another reason was increased complexity of financial instruments and interconnectedness of global market & Standardization of contracts.
A commodities exchange is an exchange where various commodities and derivatives products are traded. Most commodity markets across the world trade in agricultural products and other raw materials (such as wheat, barley, sugar, maize, cotton, cocoa, coffee, milk products, pork bellies, oil, metals and more) and contracts based on them. These contracts can include spot prices, forwards, futures and options on futures. Other sophisticated products may include interest rates, environmental instruments, swaps or ocean freight contracts.
Main commodity exchanges worldwide:
- Chicago Board of Trade (CME Group) CBOT
- Chicago Mercantile Exchange (CME Group) CME
- New York Mercantile Exchange (CME Group) NYMEX.