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Since 2008, one of the topics I am frequently asked about is commodity investing in regards to both individual commodities and index investing. In 2003 investment in commodities was estimated at $15 billion and is now north of $200 billion. The rise in popularity is mostly attributed to two reasons. The first being the risk diversification benefits of adding commodities to a portfolio and the second being a hedge against inflation.

There have been many studies to support these claims, and this led to the beginning of what is now referred to as financialization of commodities. Over the past few years, I have heard from investors about their desire to invest in commodities but have found that many do not understand or misinterpret the benefits of investing in commodities. This article is to address a few of these misunderstandings and help guide your future commodity investments. By no means is it designed to be all encompassing. It is written to better equip investors who maintain their own portfolios and help develop questions for those that use an advisor.

One of the reasons I hear investors say they want commodities in their portfolios is to hedge inflation risk. I view this as one of the biggest misunderstandings regarding commodities. Commodities do not hedge against inflation risk. Before you rush to judgment, please let me explain. If inflation is expected, then it is possible for stocks to have positive returns (determined by their ability to pass through inflation), it is possible for bonds to have positive returns (determined by the amount of inflation priced into the yield curve), and it is also possible for commodities to have positive returns. This has been proven in studies by showing positive correlation between expected inflation and the returns of these three asset classes.

What commodities hedge against is unexpected inflation. It has been proven that stocks and bonds have negative correlation to unexpected inflation, but commodities have positive correlation to it. This is why financial experts say commodity investing is an inflation hedge when added to a portfolio. Please, before investing, take the time to understand the difference between expected and unexpected inflation and their effects on asset classes. Also, no two commodities are the same and therefore if you are looking to protect against unexpected inflation, it would be unwise to simply pick a random index and think everything is great. Storable commodities serve as the best hedge. They are directly related to economic activity and have positive correlation with unexpected inflation. Historically, energy commodities have served best to achieve protection against unexpected inflation. In addition, metals share these characteristics but to a lesser degree.

Just like no two commodities are the same, no two commodity indexes are the same. The two most popular commodity indices are the S&P GSCI and the Dow Jones-UBS Commodity Index. However, most investors have asked me about ETF investments, so I will focus on two to discuss my next point. The two ETFs I will focus on are the Powershares DB Commodity Index Tracking (DBC) and the iShares S&P GSCI Commodity Index Trust (GSG). Commodity indices vary by composition, weighting scheme and purpose. As of the last prospectus, DBC has 12.375% exposure to light crude oil, heating oil, RBOB gas and Brent Crude oil. This is important because heating oil and gasoline are refined oil products, therefore, their prices move closely with crude oil. This means that investors have 49.5% of their commodity investment in energy (specifically oil and its byproducts). This index contains no platinum and no live stock. The Commodity index GSG takes this exposure further and has weights of 29.27% in crude oil, 17.72% in Brent crude, 7.99% in gas oil, 5.01% in unleaded gas, and 5% in heating oil (numbers taken from last prospectus). This gives investors an exposure to energy of 64.99%. The point is not to say this index or that index is better but to point out that they are all composed differently and investors need to find one that matches their investment philosophy. Weighting schemes and rebalancing periods will differ for all indexes. For example, GSG's weighting scheme is determined on the basis of the five-year average, which is referred to as the "world production average" (for more information please see the prospectus). Indexes may also roll contracts for specific purposes; for example, they may roll contracts on certain dates to limit losses when the market is in contango and on another date to max the roll yield, when the market is in backwardation, they may roll the contracts at predetermined dates without return maximization in mind, and some will rebalance less often to keep expenses down (FYI Commodity returns are made up of spot returns, collateral returns and roll returns). Each ETF will differ in which contracts it is invested in as well, which is discussed later in this article.

I would like to discuss one last topic before diving into individual commodities. Ke Tang and Wei Xiong recently published a research report in the Financial Analyst Journal (Volume 68, number 6) titled Index Investment and the Financialization of Commodities. I highly recommend all investors read this article because investors need to be aware of the results when investing in commodities. Below is an excerpt from the study,

concurrent with the rapidly growing index in commodity markets since the early 2000's, prices of non-energy commodity futures in the United States have become increasingly correlated with oil prices; this trend has been significantly more pronounced for commodities in two popular commodity indices. This finding reflects the financialization of the commodity markets and helps explain the large increase in the price volatility of non-energy commodities around 2008.

The two indices they are referring to in this passage are the S&P GSCI and the Dow Jones-UBS Commodity Index. Again, I highly recommend reading this article and determine how the findings may affect commodities in the future and how this will affect your investments. One of the reasons given for commodity investing is risk diversification. Investors should take the time to understand the effects of financialization, how it has changed correlations among commodities, and what effect this will have on portfolios in the future.

One aspect of commodity investing that I often hear is that futures prices are the expected future price of the commodity. For example, "the ten month oil contract is less than the spot price, this means oil is expected to decline." This is not the case as commodities are mostly determined by the business cycle (supply/demand) and a concept known as real options under uncertainty. Also, futures prices are chiefly determined by no arbitrage pricing models. I will demonstrate first with futures contracts on the S&P 500 because most investors relate better with stocks. One day an individual started a conversation with me while I was at the gym. He asked me what I do and I told him I was in finance. He then told me that he just sold all his stocks because the futures price on the S&P 500 was lower than the current price, which means the "experts" expect stocks to go down in value. This couldn't be further from the truth. The futures price for the S&P contracts are determined by the spot rate, the continuously compounded interest rate, the continuously compounded dividend yield on the asset, and time to expiration. The actual formula is F0,T = S0e(r - div)T. If the dividend yield is greater than the interest rate (which was the case when this individual made this comment to me), the futures price will be less than the spot price. The closer the futures contract is to expiration, the more the spot price will determine the futures price. The further from expiration the futures contract is, the more the rate and dividend yield will determine the price of the futures contract (relative to shorter expirations).

The no arbitrage pricing mostly holds true for commodities with slight variations. We replace the dividend yield with a lease payment. An easy way to think of a lease payment is as follows; if we borrow an asset we have to pay a lease rate, if we buy an asset and lend it out we receive a lease payment. The formula is, F0,T = S0e(r - lease)T. This holds for storable and non-storable commodities. When a commodity can be stored (a.k.a. carry) investors must take into account seasonal variations in supply and demand. Storage (when feasible) cost money, so F0 is higher because price must compensate the merchant for financial and physical storage cost. Thus the formula is F0 = S0e(r + storage)T.

Thus far we have ignored one important element into pricing storable commodities, and this element is what mainly differentiates commodity futures pricing from equity future pricing. We have ignored the convenience yield. (As a side note, some authors use the definition of convenience yield to mean lease rate) There are business reasons for holding commodities, such as farmers and food manufacturers who use corn, and it is essential that they hold inventories. By storing commodities (corn in this example), it provides the farmer/food manufacturer protection. If there is a disruption in corn supplies (such as the current drought), they have the inventory to keep producing. If there is no disruption and they have an oversupply, they can sell the extra supply on the market. The convenience yield is a nonmonetary yield, therefore it is only earned by those with business related reasons to hold commodities. This makes the convenience yield hard to observe, and there may be no way to earn the convenience yield in a cash and carry trade. This in turn produces a no arbitrage region rather than a no arbitrage price. The formula is F0 = S0e(r + storage - Convenience)T. I stated earlier that if you are investing in commodity indices, it is important to know what contracts the index is investing into. This will have varying effects on the share price and share behavior of the ETF in relationship to spot prices, so make sure your investment fits your goals.

Each commodity has its own characteristics that affect prices. I won't go into detail on every commodity but will demonstrate with two, natural gas and corn. For those interested, a popular natural gas ETF is UNG and a popular corn ETF is CORN (again, please understand how they are constructed so you can understand how they will vary from the spot price). Historically an important feature for natural gas is it's been expensive to transport internationally, so prices and forward curves tend to vary by region. Historically, it's also been expensive to store once a well has began production. Seasonality has historically seen peak demand in winter due to heating. This means that there is steady production with variable demand, which can lead to large and predictable price swings. However, there has recently been an overabundance of natural gas in the United States and due to government regulation, power producers have began using more natural gas in their electricity plants, which has increased demand during summer.

Corn has its own history of seasonality, but this too may change due to new government regulation regarding ethanol. On January 9, 2013, Bloomberg released an article titled "Tightest corn crop since '74 as Goldman Sees Rally: Commodities." In the article, it states that ethanol distillers used 41% of the corn crop last year. As time goes on, the demand from these users will continue to increase as long as the government continues current policies. This will have a lasting effect on the seasonality and pricing of corn. I use these two examples to demonstrate to investors to do their homework because each commodity has its own story and its story may change in the future, which in turn may reduce the benefits of commodity investing.

This article is not meant to be all encompassing and is meant to entice the reader to further their knowledge on commodities to better equip themselves with proper investments for their goals. There are many textbooks that go into extreme detail on these topics such as the no arbitrage pricing models. I recommend to all investors that are interested in commodities to do further research. Remember, it's not as simple as "I want to invest in gold because the guy on TV said the word inflation and recommended gold."

Source: Insight Into Commodity Investing