The past couple of weeks I have gotten several questions about investing in commodities for diversification and an inflation hedge, both at the office and on the radio.
First of all, many people confuse investing in commodities with commodity futures. While these investments are related, they are very different and have different uses. Commodities are tangible assets such as gold, silver, copper, zinc, wheat, corn, gasoline and oil, among others. Futures contracts are simply speculation or hedging on the future price of these commodities.
Let’s say you think corn is going to go down in price in the future; you could agree to sell corn in November for the price of $8 a bushel. Sometime between now and the date in November you could purchase the corn at a lower price, say $6 a bushel, and fulfill your sale of corn in November. This will give you a $2 profit on corn you never owned or intended to own.
If the price of corn goes against you and between now and November corn continues to rise to say $11 a bushel, you will lose $3 a bushel and will have to write a check for the difference. On 10,000 bushels this is a $30,000 loss.
Futures contracts are highly speculative, partially because of the uncertainty of the price of a future good but also because the futures contract can be entered into with very little cash out of your pocket. So a 10,000 bushel contract of corn, worth more than $80,000 can be controlled for as little as $8,000. For $8,000, you could make $20,000 or lose $30,000, in the examples above.
With the amount of leverage available for these contracts, it is easy to see how people can get into trouble if they don’t know what they are doing. Also, it is easy to see how companies like MF Global can get into deep trouble making the market for futures contracts.
Commodity investing, while similar to above, is actually investing in the commodity itself. The most common, for most of us, is buying gold and silver. Commodities in general are fairly sensitive to the effects of inflation and therefore are a good hedge against inflation going forward.
Investing in commodities can be done by taking physical delivery or by using an exchange-traded fund (ETF) that invests in the commodity. Taking physical delivery is fairly easy if you are buying precious metals, because you can get a lot of value in a small quantity. Taking physical delivery of 10,000 bushels of corn, however, can be a little more cumbersome for most of us.
Using an ETF for some of your commodity investing can be very convenient because you don’t have to take delivery and you still get most of the advantage of the movement of the underlying asset. ETFs also allow you to hedge your hedge, if you will, by protecting the downside with limits and options.
There is always some counter-party risk, but in “normal” markets this is minimal. There is usually plenty of liquidity to provide a market for the ETF shares. I am not a big fan of mutual funds for any investing, but you can also invest in commodities using mutual fundsif you like. Generally, using a mutual fund will pretty much eliminate the counter-party risk since mutual funds are required to redeem their shares for their investors on demand.
In conclusion, commodities should be a part of a portfolio in one form or another if your risk tolerance allows. Whether you use futures contracts, ETFs, mutual funds or take physical delivery, commodities can provide an inflation hedge and additional diversification to your investments. ✯
Gary L. Rathbun is the president and CEO of Private Wealth Consultants, LTD.
