Commodities - Trading or Long Term Hold?

[ringledman]

What are peoples thoughts on how to invest in commodities?

I hold a percentage in oil/gold/agricultural/metals as I believe in the long term bull market in commodities.

Some of these have dipped to below purchase price but this doesnt concern me as I think the long term will be very rewarding.

Nonetheless, some people say that commodities can only be traded, dipping in and out on a weekly basis.

What are your thoughts? cheers.

 

[Marc]

[FONT=&quot]Commodity Investments –do they make sense?[/FONT]
[FONT=&quot]Investors may be considering making investments into commodities through Exchange Traded Funds (ETFs) yet in my experience, many lack a full understanding of the potential hidden costs associated with these investments.[/FONT]

[FONT=&quot]If one could invest directly into the underlying commodity at the spot price, the conclusions reached here might be different. However, to invest in the spot price one needs to take (or be able to take) physical delivery of the underlying commodity. Whilst this might be practical for certain commodities such as gold or silver, it certainly isn’t practical for oil, corn, wheat or gas etc. Retail investors will therefore typically look to options such as an ETF to gain access to their commodity of choice. It is for this reason that they need to understand the differences between the commodity spot prices and the rolling futures contract. [/FONT]

[FONT=&quot]The performance of a commodity ETF is largely dependent on three variables: [/FONT]

[FONT=&quot]1)[/FONT][FONT=&quot]Changes in the spot price, [/FONT]
[FONT=&quot]2)[/FONT][FONT=&quot]Interest income on un-invested cash, and [/FONT]
[FONT=&quot]3)[/FONT][FONT=&quot]The ‘roll yield’[/FONT]

[FONT=&quot]While the first two are easily understood by most investors, the roll yield is more complex. [/FONT][FONT=&quot]
[/FONT]

[FONT=&quot]By way of an illustration of the possible impact, we looked at the difference between rolling over a futures contract compared to the spot price of sugar between April 2004 and December 2008: [/FONT]

[FONT=&quot]In this example, the impact of the roll yield was very significant and you would have been down 126% compared to the spot price of sugar over this period.[/FONT]

[FONT=&quot]Of course the reverse is also true and a large contributor to differences in commodity futures returns has been the return derived from rolling futures contracts before they expire because this roll return can also be positive. This has been the case with many markets (such as those for energy contracts) in the past. [/FONT]
[FONT=&quot]
The message here is that investors considering investing in a commodity ETF should most definitely be interested in the shape of the curve of forward contracts. [/FONT]

[FONT=&quot]Conclusions[/FONT]
[FONT=&quot]At first sight, commodity investments appear to have some interesting investment characteristics. However, they are totally reliant, in terms of price performance, on what the next investor will pay for them. There might be a risk premium embedded in them, but it is far from clear to what extent this can disappear during inflows of “hot money”. That is to say that the delicate balance between hedgers and speculators can be easily unbalanced. [/FONT]

[FONT=&quot]Remember that past performance is no guarantee of future returns and just because commodity investment may have delivered good returns for investors in the past, does not mean that the same will be true in the future.[/FONT]

[FONT=&quot]Finally, a study in 2004 found the average excess return from commodities was not reliably different to zero and there is also little evidence to support commodities' reputation as a diversifier and inflation hedge.[/FONT]

[FONT=&quot]I have analysed the CRB Commodity Index in US$ since 1956 with the following results:[/FONT]

[FONT=&quot]Monthly data Oct 1956 to Jan 2009[/FONT]
[FONT=&quot]One month Treasury Bills
Annualised return 5.25%pa
Annualised standard deviation 0.79%[/FONT]
[FONT=&quot]
[/FONT]
[FONT=&quot]CRB Commodity Index
[/FONT][FONT=&quot]Annualised return [/FONT][FONT=&quot]1.37%pa[/FONT]
[FONT=&quot]Annualised standard deviation 11.69%
[/FONT]

[FONT=&quot]What this means is that, on average, an investment in commodities does not appear to reliably offer an expected premium above cash rates. Investment is therefore pure speculation, for every long position there is a short. For you to win on your bet that the price will rise, I have to lose my bet that the price will fall. Over the long run, the average expected return from all the bets placed is zero, less the costs of engaging in the process - which as we have seen can be considerable.[/FONT]

[FONT=&quot]Commodity investments might make sense if you could buy at close to the spot price and avoid storage and insurance costs. This is where certain options like investing in bullion might give investors a sporting chance.[/FONT]

 

[ringledman]

Marc I'm not really interested in hearing about whether commodities are a good investment over the long term as I realise that inflation adjusted commodites were their cheapest for decades around 2000.

As commodites rise and fall in long booms and busts (typically 20+ years) this commodites secular bull market has a log way to go before it blows out.



The 'quantitative easing' and increase in the money supply that the world's governments are playing out will likely lead to rampant inflation where commodities will be a key asset to own.

Anyway back to the question...

 

[ringledman]

quote]

 

[ringledman]

I have analysed the CRB Commodity Index in US$ since 1956 with the following results:

[FONT=&quot]One month Treasury Bills [/FONT]
[FONT=&quot]Annualised return 5.25%pa[/FONT]
[FONT=&quot]Annualised standard deviation 0.79%[/FONT]


[FONT=&quot]CRB Commodity Index [/FONT]
[FONT=&quot]Annualised return [/FONT][FONT=&quot]1.37%pa[/FONT]
[FONT=&quot]Annualised standard deviation 11.69%[/FONT]


[FONT=&quot]What this means is that, on average, an investment in commodities does not appear to reliably offer an expected premium above cash rates. Investment is therefore pure speculation [/FONT]

This analysis is rather basic and simplistic. You would have to be a fool to have owned commodities from 1956 to now and ridden down the full secular bear market of the 1980s to 1990s where equities were the only thing to own.

I propose commodity investment during the secular commodity booms as we are in now. This started in 2000-2001 and therefore if you look at the historical analysis of previous commodity booms we are currently 1/4 to 1/2 way through the current bull market.

When commodities become a mainstream investment bought by 'conventional' investors who follow the herd or when financial advisors start tipping it then I will be getting the heck out of commodities.

For the contrarian investor who understands the cyclical nature of all financial assets then currently there is only one real asset to invest in.

Property is done for globally for at least a decade. Yields are still too high against the long term typical yield of 7% and need to undershoot to around 10% before property becomes cheap again.

Equities will come back strong but really they are only 1/2 to 2/3 of the way through the bear market that commenced in 2000. Again history shows equity markets go on long bull markets 20+ years and slightly shorter bear markets. Equities will underperform for a fair time longer.

The only equities to buy currently are emerging markets where the P/E ratios, low debt, cash rich, growing middle classes and growing consumerism justify it.

Nonetheless commmodities are the place to be.

http://www.zealllc.com/2008/commcycl.htm
http://www.zealllc.com/2008/cbmarket.htm

The upward cycle is far from over.

 

[PMU]

I think commodities should be part of every investor’s portfolio, but you need to know in what you are investing.
Investing in a commodities ETF, as Marc pointed out in his post, is not the same as buying commodities. You are not investing in physical commodities but in commodities futures contracts. Commodity ETFs are based on indexes that track continuously rolled over futures contracts. You make a positive return on a futures contract when the spot price at maturity is higher than was expected when the contract was purchased. (And you lose when the spot price is lower.) So basically you make your return, inter alia, (+ or -) on spot price relative to the price of the contract.
Then there is the ‘roll yield’. The key point of the roll yield is that you can get a positive return even when the spot price is constant. As the roll yield is separate from the physical commodity price, the roll yield a pure alpha play, i.e. you can gain excess returns even if the spot price remains constant (where the contracts price is lower than the spot price (and you are long)). [Note: it’s much more complex than this.] The point being that commodity investment is a way for the amateur investor to add some alpha (i.e. non-market related return) to their portfolio.
You also get diversification benefits with commodities. While the long term return on commodities may not be significantly different to the return on equities, the return on commodity futures is negatively correlated with equity returns. Here is the relative price movement of a commodity ETF (GBP-denominated) vs domestic market equities:
http://uk.finance.yahoo.com/q/bc?t=1y&s=%5ESTOXX50E&l=on&z=m&q=l&c=lcne.l
[This is an example and not a recommendation to invest in this ETF.]
But you really have to do your homework on this; understand how commodity futures work and how the particular index you select is constructed. You also have to weigh up the potential returns from alpha vs counterparty and currency risk.