Friday, December 09, 2011

Commodities as Alternative Investments

CFA Level 1 - Alternative Investments

Commodities are raw materials that are sold in bulk, such as oil, wheat, silver, gold, pork bellies, oranges and cocoa. They are generally raw materials that are eventually used to produce other goods such as oil for gasoline, cocoa for chocolate, wheat for bread, etc. As such, they give an investor the opportunity to invest in the materials that a country (or corporation) produces as well as those that it consumes. Most larger manufacturers buy the commodities they need on the "spot market," where the full cash price is usually paid on the spot. Speculators typically buy and sell commodities with options and futures contracts.

Types of Commodity Investments
A commodity-linked security refers to a security whose return is dependent to a certain extent on the price level of a commodity, such as crude oil, gold, or silver, at maturity. For example, the principal of a commodity-linked bond is indexed to movements of a commodity index such as precious metal or oil. 

Commodity derivatives include both exchange-traded and over-the-counter commodity derivatives such as swaps, futures and forwards. They are used to hedge risk and to take advantage of arbitrage opportunities.

Collateralized Commodity Futurespositions involve taking a long position in the futures contract of your choice and then purchasing the amount equal to your futures position in T-bills. The source of return comes from the interest you earn on your T-bill position and the movement of the futures price.

Motivations for Investing in Commodities, Commodity Derivatives, and Commodity-linked SecuritiesCommodities offer investors a number of benefits: 
  • Hedge Against Inflation: Commodity cash prices may benefit from periods of unexpected inflation, whereas stocks and bonds may suffer. Commodities are "real assets", unlike stocks and bonds, which are "financial assets". Commodities, therefore, tend to react to changing economic fundamentals in ways that are different from traditional financial assets, particularly with respect to inflation. Commodity prices usually rise when inflation is accelerating, so investing in commodities can give portfolios a hedge against inflation. Conversely, stocks and bonds tend to perform better when the rate of inflation is stable or slowing. Faster inflation lowers the value of future cash flows paid by stocks and bonds because those future dollars will be able to buy fewer goods and services than they would today.
    However, this inflation advantage is captured more efficiently by direct investment in commodities than, for example, investment in commodity-related equities whose prices also reflect the financial prospects of the issuer or actively managed commodity futures accounts, which tend to reflect the manager's skills at selecting the right commodities.  
  • Performance/Return: Investor interest in commodities has soared in recent years as the asset class has outperformed traditional assets such as stocks and bonds. Over the five-year period ended March 31, 2006, the Dow Jones AIG Commodity Index has returned 10.6%, versus 2.6% for the S&P 500. Part of this superior performance is attributable to a rise in commodity prices driven by increased demand from China and other emerging countries.
  • Enhanced Diversification: Portfolio diversification is the primary benefit of holding commodities. The reason for that is the commodity investor is exposed to commodity futures prices. Changes in those prices reflect changing expectations about future supply and demand for commodities. Factors that change expectations - such as a weather event in the Midwest or a strike in a copper mine in Chile - typically don't have anything to do with stock and bond markets.

Forms of Commodity Investing
Investing in commodities comes in two forms: passive and active:

  • Passive investing is a strategy used by investors who are using commodities as a risk diversification tool. For example, when inflation picks up, it tends to hurt fixed income securities and equities to some extent. However, prices of commodities tend to rise during these periods. This helps diversify your portfolio. Commodity investing has long had a reputation for exceptional volatility and risk but there is now a small but growing number of excellent, high-quality index-based commodity funds available that provide a relatively conservative way to invest in commodities. The management attempts to minimize price fluctuations and provide overall risk management in several ways. The selection and weighting of assets in a portfolio are typically reviewed annually or when there is a major change in an industry or even a drastic change in usage of any given commodity. This provides some overall risk reduction in commodity index funds and makes them suitable for investment by investors with limited commodity backgrounds.
    Index funds usually consist of long positions on the contracts. Short positions are usually not taken.
  • Active investing or actively managing a position in the commodities market can provide good performance results. In periods of economic growth, commodities are in strong demand to satisfy production needs. Because commodity or raw material prices tend to move more quickly in reaction to economic fluctuations than do the prices of the related finished goods, an active approach could lead to economic gains if trading activities are closely monitored and managed by the investor.
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