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Types Of Markets Part 10: Commodities Part 3

In the last two articles we looked at what commodities are, the categories that they are broken up into, a brief history of commodities and how the commodities market has evolved into what it is today, how investors use commodities to diversify their portfolios, we took a look at some real commodity exchanges (such as The Chicago Mercantile Exchange) as well as how to invest into commodity futures.

 

This week we are basically going to dive a little deeper into investing commodities through stocks, ETF’s, ETN’s, mutual and index funds, commodity pools and Managed Futures.

 

All of this can be quite overwhelming so let us break it down into smaller bite sizes.

 

Investing in Commodities Through Stocks

 

This most commonly done by investing in the stocks of a company that deals in the particular commodity you are interested in. For example, investors that are interested in minerals such as gold or silver could buy stocks of mining companies, refineries, smelters, or companies that deal with bullion. If the investor is interested in the livestock and meat sector they could buy shares of companies that own many farms or slaughterhouses or factories that process meat or food shipping companies. It’s a roundabout way of investing in the industry of the commodity rather than buying the raw goods yourself.

 

This would be ideal for investors that are looking for something that’s less volatile that the futures contracts. Stocks can also be easier to buy, hold, track, and trade.  The advantages of doing this is that it is easier to by the stock since most investors already have a brokerage account, stocks are generally more liquid and public information on the company is available on the internet. Obviously, you still need to do your research and treat it in the same way you would buy any kind of stock (add hyperlink to warrens articles)

 

Some of the Disadvantages are that stocks are not a true representation of the commodity, they do not reflect the prices of the of actual goods. On top of this, the stock can easily be influenced by company-related factors which could have nothing to do with the actual commodity.

 

Investing in Commodities Through ETF’s and ETN’s

 

Exchange-Traded Funds (ETF’s) and Exchange-Traded Notes (ETN’s) are traded a lot like the stocks, allowing the investor to profit from fluctuation in prices without having to invest in the actual commodity.

 

These ETF’s and ETN’s  track the price of a certain commodity (or a group of commodities that make up an index) by using futures contracts. The ETF is oftentimes backed by the actual commodity that is held in storage while the ETN is an unsecured debt security that is designed to emulate the price fluctuation of a particular commodity or commodity index that is backed by the issuer.

 

An advantage of this is that it allows the investor to participate in the fluctuation of price just like with stocks, however, they generally do not require a special brokerage account. There is also no management fees since they trade like stocks.

 

The disadvantage is that not all commodities have ETF’s or ETN’s that are associated with them. On top of that, large movements in price in the commodity are not always reflected by the ETF or the ETN. ETN’s specifically also have credit risk associated to them since they are backed by the issuer.

 

Investing in Commodities Through Mutual and Index Funds

 

This is very similar to investing in the stocks of companies that deal in the commodity in the sense that you as an investor will not be directly involved in the raw goods. By investing in a fund that is made up of companies that deal in the commodity you are indirectly investing in the commodities market. These companies that are connected to the industry, such as energy, agriculture or mining, their shares will be impacted by the fluctuation of commodity prices, however, there are numerous factors outside of the commodity that could also cause fluctuations in price such as internal company related factors and general stock market fluctuations.

 

That being said, there are a small number of commodity related index funds that will provide the investor with more direct exposure to commodity prices. This is achieved by the fund investing in more futures contracts and commodity linked derivative investments.

 

The advantages of investing in a fund are that you would get the benefit of professional money management, a more diverse portfolio as well as more liquidity.

 

The disadvantages would be that some funds have high management fees or hefty sale charges. So, this would only be a viable option if you have a rather large amount of capital to invest. For your average day trader, you probably wouldn’t have too much benefit of investing in a fund in this way.

 

Investing in Commodities Through Commodity Pools and Managed Futures

 

Firstly, lets understand what a commodity pool is. It is similar to a fund in the sense that it is run by a person or a limited partnership called a Commodity Pool Operator (or CPO). The CPO gathers capital from various investors and puts it all together into a pool which is then invested into futures contracts and/or options.

 

This system also incorporates the use of a Commodity Trading Advisor (or CTA) that advises the CPO on investment decisions for the pool. CTAs must be registered with the Commodity Futures Trading Commission (or CFTC) and are usually required to go through a process where a background check is done before they can provide investment advice. This ensures that there isn’t someone who just watched a couple of YouTube videos on forex trading and now wants to advise a CPO on investing.

 

The advantages to this are that as an investor you get the benefit of having your investments managed for you as well as the peace of mind knowing that a CTA is also working to ensure that the investment will be profitable. On top of that, because of the pooled structure, the manager or CPO is able to invest in more opportunities that without that amount of money pooled together, wouldn’t be possible otherwise.

 

The disadvantage to this system is that if investors choose to close the fund, all investors will have to contribute the same amount of money. So, it is important to do your research first to ensure you are pooled in with other investors that have similar capital to yourself.

 

So, as it has become quite apparent, there are many ways of getting involved in the commodities market and each one can be tailored to suite your individual investment needs. Whither you are a day trader looking to trade new markets or an investor with a lot of capital that you would like to have managed for you. The commodities market can be a very complex thing to get into but as long as you know what you are looking for and you do the required amount of research, you should find your space and end up with decent returns on your investment capital.

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