Commodities Investing-III::Participants & Exposure

There are essentially two ways for investors to gain broad exposure to changes in commodity prices. First, there are several long-only commodity indices that give investors exposure to passive long positions in a number of commodity futures contracts. This allows them to participate in gains that would otherwise only be earned from holding individual positions in these contracts. An investment in a commodity index does not give the investor ownership of the cash commodity, but rather, an exposure to changes in the future expected price,7 thus allowing an investor exposure to a broad section of the commodities market.

The second way for investors to gain broad exposure to commodities is through managed futures products that take both long and short positions in various commodities using different trading strategies. There are advantages and disadvantages to each type of product. We will first look at long-only commodity indices, how they are constructed, and how an investor might utilize these products to invest in this asset class.

LONG-ONLY COMMODITY INDICES
Just as stock index funds seek to replicate a portion of the equities market, long-only commodity indices give an investor exposure, typically through futures contracts, to a crosssection of the commodities market. As with equity indices, that have specific weights in individual securities, commodity indices have weights to certain areas of the commodity market, such as energy, grains, metals, or livestock.

Commodity Incdices and their Construction
Commodity indices can be constructed using several different methodologies, all of which will impact the returns and the underlying volatility of the index. The three primary methodologies include production weighting, optimized weighting, or equal weighting.

Production weighting involves assigning weights based on a moving average of world production.A production-weighted index will also have a heavier weighting in sectors that may be more important in the economy such as oil and natural gas. As a result, these allocations will have a disproportionate impact on the performance of the index.

An optimized-weighted index includes specific constraints and objectives such as correlation with inflation, negative correlation to equities and fixed income, a focus on liquidity, and the sectors that are most relevant.

Finally, an equal-weighted index keeps price fluctuations in any one sector from disproportionately impacting the index, but does not over/underweight sectors that may be more important in the economy, such as oil and natural gas, which are key elements in most industrial economies.

Commodities Investing-II::Participants

There are two groups of participants in the futures markets.

The first group of participants comprises buyers and sellers of goods, known as commercial participants, or hedgers. This group includes farmers and other producers of goods who wish to sell their products at a specified price as well as buyers of commodities who wish to hedge against price increases.Commercial participants are not in the futures markets to make a profit, but rather to protect themselves against price changes. For example, if the price of corn drops before the time the farmer sells his futures contract, he is still guaranteed the price at which he sold the contract.

The second group of participants in the futures market is investors (also known as speculators). Investors serve an important function in the futures market because there is often an imbalance between those wanting to sell contracts and those wanting to buy. Investors provide much needed liquidity to the futures markets and are compensated for taking on this role.

One of the distinguishing factors regarding the futures markets is that they exist primarily to protect against price uncertainty for buyers and sellers of goods. As a result, most of the participants are not in the market to make a profit, but
rather to hedge against price risk. This can sometimes create opportunities for investors (or speculators) to make a profit.

Commodities different and Paper Assets!!
Commodities differ from paper assets (equity and fixed income) in that they require storage costs. While paper assets can be held in brokerage accounts at little or no cost, commodities such as crude oil, wheat, or livestock obviously cannot be stored in a vault or electronically in a database and storage costs for commodities can sometimes be significant. Storage costs must be a consideration for an investor, as they will impact the pricing structure of futures contracts of individual commodities. For this reason, the change in the price of futures contract for a commodity may vary from the change in the price of the underlying commodity because futures contracts take into account these storage costs. As a result of storage costs, longer dated futures contracts (for example, delivery in six months), will generally be priced higher than shorter dated futures contracts for delivery in one month.

Commodities Investing!!-I

Commodities are broadly defined as “generic, largely unprocessed, goods that can be processed and resold.” Investing in commodities represents an investment in the basic production inputs in the economy. By investing in commodities, an investor gains exposure to changes in commodity prices, which are ultimately driven by global supply and demand. A growing economy will see increased demand for commodities due to increased consumption, which puts upward pressure on prices. Higher prices typically result in increased supply coming online, which consequently drives prices lower. The key factors helping to drive demand over the long-term are a growing population, industrialization, and consumption while supply can be impacted by geopolitical events, weather patterns, or available capacity for processing commodities.

INVESTING IN COMMODITIES: AN OVERVIEW OF THE FUTURES MARKET
Investing in commodities is usually accomplished through the use of futures contracts and, therefore, understanding how the futures market functions is important.

Futures markets have been in existence for centuries and provide an efficient vehicle for buyers and sellers of goods to reduce price uncertainty and risk. A simple example would be a farmer who harvests a corn crop in the fall, but wants to guarantee a selling price several months prior to the harvest. The farmer can go to the futures market and sell a contract, whereby the purchaser of the contract agrees to buy his corn at a set price several months in the future. This transaction essentially eliminates the uncertainty that corn prices could drop prior to the time the farmer brings his crop to the market.

Alternatively, a company that buys large quantities of corn, may want to hedge its risk of rising corn prices by locking in a set price for some point in the future by buying a futures contract on corn. Although the purchaser of a futures contract agrees to take physical delivery of the goods upon expiration of the contract, most futures contracts are settled on a cash basis. In purchasing a futures contract, the investor posts a margin, that represents a percentage of the actual price of the futures contract and can be as little as 5% of the cost of the contract. As the price of the underlying commodity fluctuates and the value of the contract changes, the account is “marked to market” on a daily basis and the investor may be required to post additional funds to the account if the account value falls below a specified level.