Commodities

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Commodities are marketable items produced to satisfy wants or needs. Economic commodities comprise goods and services.[1]

In terms of financial markets, commodities are raw materials that are traded on futures trading markets. Examples include oil, crops and precious metals.

The primary purposes of commodities futures trading are:[2]

  1. Hedging - locking in future commodity prices by farmers, industry and other parties.
  2. Speculation - attempting to profit on commodity price movement by speculators.

In terms of individual portfolio management, there are also mutual funds and exchange-traded funds (ETFs) that attempt to track and capture future price appreciation of commodities.

Regulatory

The Commodity Futures Trading Commission (CFTC) is the federal government agency that regulates the commodity futures, commodity options, and swaps trading markets.[3][note 1]

The Commission was established as an independent agency in 1974, assuming responsibilities that had previously belonged to the Department of Agriculture since the 1920s. The Commission historically has been charged by the CEA with regulatory authority over the commodity futures markets. These markets have existed since the 1860s, beginning with agricultural commodities such as wheat, corn, and cotton.

Over time, these commodity futures markets, known as designated contract markets (DCMs) regulated by the Commission, have grown to include those for energy and metals commodities such as crude oil, heating oil, gasoline, copper, gold, and silver. The agency now also oversees DCMs for financial products such as interest rates, stock indexes, and foreign currency.

Risks

Direct trading of commodities via the futures markets tends to be very risky because commodity prices can be volatile. In addition leverage is typically used when speculating with financial futures. Direct trading in commodity futures is not ordinarily a part of an individual investor's portfolio.

Commodities investments via mutual funds and ETFs are comparatively safer and more appropriate for individual investors, but still come with material risks:

  • Commodities have significant price volatility and can have positive or negative multi-year periods of return,[4] but over the very long term tend to have low or no real inflation adjusted return.[5] By themselves their risk return relationship is not particularly attractive.
  • Commodity prices are often sensitive to economic cycles, and may experience price declines at the same time as stock/equity investments.
  • Commodities are traded via futures and do not exactly equal the current "spot" prices. Thus returns on commodity based funds may have material variances in returns vs. popular commodity price indices. The causes of this are "contango" and "backwardation".[6] These result due to rollover of futures contracts because individual investors do not want to take delivery of the actual commodities.
  • Commodity funds tend to have higher expense ratios than comparable stock and bond funds.
  • Some commodity ETFs issue K-1 tax forms which can complicate and delay individuals annual tax return filings.[7]

Role in a portfolio

Commodity spot prices, as an asset class, over the very long term, have not generated a significant real return. Commodity mutual funds and ETF's invest in futures contracts that derive excess returns over the risk free rate of return from two sources:

  1. Changes in futures prices
  2. The roll yield—which can be either positive or negative—that results from replacing an expiring contract with a further out contract in order to avoid physical delivery yet maintain positions in the futures markets.[8]

Some individual and institutional investors include commodities as part of their portfolio for purposes of diversification of returns and inflation protection. Commodities do provide some level of protection against unexpected inflation. Protection against expected protection is more modest.[9]

Table 1. Commodity Index Returns[10]


(View Google Spreadsheet in browser, then File --> Download as to download the file.)
Note: If the spreadsheet is blank, select a different sheet, then back to that sheet. The image will be refreshed.

Funds

Open-ended mutual funds

  • PIMCO CommodityRealReturn Strategy Fund Institutional (PCRIX) is an open-ended mutual fund which tracks Bloomberg Commodity Total Return Index[note 2] with collateral in inflation-indexed bonds. Expense Ratio 0.79%. Available at Vanguard Brokerage Service for $25,000 initial investment and a transaction fee.
  • Vanguard Commodity Strategy Fund Admiral Shares (VCMDX) relies on commodity derivative securities to maximize inflation protection by seeking to outperform its benchmark and reduce the long-term volatility of a well-diversified, balanced portfolio. The commodity-linked exposure will be collateralized with a mix of short-term Treasury inflation-protected securities (TIPS) and Treasury bills (T-bills). The fund has a lower expense ratio (0.20%) than most peers and a more modest allocation to energy commodities than some others. $50k minimum required.

ETFs

Source: Top 26 Commodity ETFs, ETF.com

ETNs

Notes

  1. A commodity is defined as:

    (1) A commodity, as defined in the Commodity Exchange Act, includes the agricultural commodities enumerated in Section 1a(9) of the Commodity Exchange Act, 7 USC 1a(9), and all other goods and articles, except onions as provided in Public Law 85-839 (7 USC 13-1), a 1958 law that banned futures trading in onions, and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in; (2) A physical commodity such as an agricultural product or a natural resource as opposed to a financial instrument such as a currency or interest rate.

    CFTC Glossary

  2. Bloomberg took over the maintenance of the Dow Jones-UBS Commodity Index on July 1, 2014. See Bloomberg Indexes to Oversee Leading Global Commodity Indexes.

References

  1. Commodity, on Wikipedia.
  2. Commodities Futures Contract, Adam Hayes, Investopedia, 28 March 2021
  3. Learning Resources - CFTC
  4. Conquering Misconceptions about Commodity Futures Investing,Claude Erb and Campbell Harvey, Financial Analysts Journal, July/August 2016
  5. Commodity prices are where they are 160 years ago,The Economist, 27 April 2020
  6. Rethinking Commodities , by Fiona Boal and Jim Wiederhold, S&P Dow Jones, January 2020
  7. K-1 Taxes Hurdle For Commodity ETFs , by Lara Crigger, ETF.com, 9 April 2018
  8. Putting Momentum into Commodities, by Paul D. Kaplan, Morningstar, 14 October 2011
  9. Commodities and short-term TIPS, how each combats unexpected inflation, Paul Bosse, CFA, Vanguard Research, June 2019
  10. Data sources:

External links

Articles

  • On Stuff by William J. Bernstein, September 2006
  • Siegel, Jeremy (May 19, 2006). "Commodities: Boom or Bust?". www.jeremysiegel.com. Yahoo Finance. Retrieved December 3, 2017.
  • Robert Greer Discusses the Benefits of Commodity Investing by Robert J. Greer, 1 March 2004
  • What the Price of Gold Is Telling Us by Congressman Ron Paul, 25 April 2006
  • Going Long on Commodities: Six ways to invest in commodities by Will Acworth, 15 May 2005
  • A Rediscovered Asset Class: Commodity Futures by raddr, 4 February 2006
  • Commodities As An Asset Class by Frank Armstrong, CFP, AIF, 15 July 2004
  • Not All Commodity Indexes Are Created Equal (Part One of a Two Part Series) by Richard Feldman, CFP, MBA, AIF, 2 June 2006
  • Are Commodities Futures Too Risky for Your Portfolio? Hogwash! by Knowledge@Wharton, 5 April 2006
  • Contango, backwardation, and all that good stuff by Prof. James Hamilton, 12 June 2005
  • CRB Indexes by CRB
  • The Great Commodities Debate Part I and Part II, Feb 13 and 14, 2008. An interview with Larry Swedroe and Rick Ferri on Seeking Alpha. Subscription required if viewed on more than one page. Disable your browser's javascript to view on a single page.

Bibliography

White papers
Academic papers