both physical commodities and commodity futures contracts has brought commodities to the masses; they're no longer reserved for the largest and most sophisticated investors.
Commodities have obvious appeal to active investors looking to generate profits from short-term price movements; the volatility of this asset class is ideal for risk-tolerant individuals who actively monitor their positions. But commodities may also have appeal to the long-term, buy-and-hold crowd; this asset class has the potential to bring both diversification and return enhancement to traditional stock-and-bond portfolios [see also 12 High-Yielding Commodities For 2012].
Of course, along with those potentially appealing attributes comes plenty of risk; the path to commodity exposure is full of potential obstacles and pitfalls that can erode returns and lead to a less-than-optimal investing
experience. Here are ten rules of thumb that will help you achieve a more successful experience investing in commodity markets:
1. Remember the Contango…And Keep It Away
Perhaps the most common–and most dangerous–misconception about commodityETFs and ETNs is that these products offer investors exposure to the spot prices of the underlying commodities. While some physically-backed precious metals ETFs such as the iShares Gold Trust (NYSEArca:IAU) and iShares Silver Trust (NYSEArca:SLV) do hold physical bullion, the vast majority of commodity ETPs on the market achieve the targeted exposure through the use of futures contracts [see also How To Lose Money Investing In Commodities].
That is very important to note, because it means that the returns generated will ultimately depend on three factors:
- Changes in spot price of the commodity
- Slope of the futures curve
- Interest earned on uninvested cash
It's not uncommon for the second point on that list to be the driving force, and the reason why returns on commodity ETPs can deviate significantly from a hypothetical investment in the spot commodity.
2. …And Keep It Away
For an investor who solely invests in futures contracts, contango may not be as big of an issue. But given the fact that commodity ETPs have soared in assets in recent years, there are a large amount of people who rely on these products for their commodity exposure, and it is highly likely that a number of them have been burned by contango. A futures-based ETP follows a strict process which, when combined with contango, slowly but surely destroys a position. The most popular kind of commodity exchange traded product is a first generation futures fund; one that simply invests in front-month futures and features an automated roll process. Here is where the issue comes into play [see also Understanding Contango: Natural Gas Example].
When and ETP's contract is about to reach maturity, the fund executes an automated roll process so as to avoid delivery. When futures are contangoed, this forces the particular fund to sell the contract low, and buy the next contract for a higher price, erasing value with the blink of an eye. When this process is dragged out over several months, these funds have a nasty habit of producing some rough returns. But how can you keep away from such a common anomaly?
It is first important to remember that first-generation futures funds, like U.S. Natural Gas Fund (NYSEArca:UNG) and U.S. Oil Fund (NYSEArca:USO), should be used as trading instruments. Their automated roll process will always fall prey to a contangoed environment, and therefore it is not often wise to establish a long term position in such a fund. Instead investors should measure their holding periods of these products in days and hours, rather than weeks and months, to help avoid the pitfalls of the auto-roll. But for those who are uncomfortable with actively trading a fund, there are now a wide variety of ETPs that are focused on eliminating contango. These next-generation products will often hold several futures contracts at once and their roll process does not always involve buying the next month's contract, but rather one that matures further into the future.
A quick glance at the index description of a futures-based fund will tell you if it is utilizing the dangerous front-month strategy, or if it is using alternative means to avoid contango. Also note that investors can use physically-backed products to avoid this issue, though that space is generally limited to precious metals [see also Three Reasons Why Gold Is Overvalued].
3. Do Not Bear False Witness Against Commodity ETNs
Most investors are aware that there are distinctions between exchange-traded funds and exchange-traded notes; ETFs hold a basket of underlying securities and may experience tracking error, while ETNs are debt securities that will expose investors to the credit risk of the issuing institution [see also Three Things Wall Street Journal Didn't Tell You About Commodities].
Most investors tend to gloss over the differences between these two product types, since they generally function in almost identical fashion. When it comes to accessing commodities, however, the differences between these two product structures can be significant. For starters, tracking error can become a big issue with products that regularly "roll" futures contracts to avoid taking physical possession; ETFs that are continuously buying and selling futures contracts are likely to deviate slightly from their target index. ETNs don't have that concern, since there are no underlying holdings; the value of these securities simply moves along with the index.
It should be noted that ETNs can also avoid the fees that come along with rolling futures contracts and implementing a futures-based investment strategy.