The search for the perfect portfolio has long been the goal for investors, as many tinker with the makeup of their underlying holdings in order to maximize returns. While there is no set standard for a portfolio, it is widely agreed that any group of holdings needs to be well diversified to deliver the most stable returns. This brings the inclusion of stocks, bonds, real estate, and more recently, commodities.
Widespread commodity exposure in a portfolio is relatively new as far as the financial world is concerned, as investors are beginning to see the advantages of adding this key element to their basket of securities. While it is true that these investments probably do not warrant an allocation higher than 5%-10%, they can have a significant impact on a portfolio and come with a long list of advantages. These investments help to hedge against inflation, as their prices tend to rise as currencies slowly devalue, and they are often the first items to gain because producers can easily pass on costs to those further down the supply chain. Also consider that the supply of commodities is limited in a sense; while farmers can grow less or more of a certain crop, commodities themselves are not subject to the inflation that currencies and equities experience when it comes to adding money to the system like one of the quantitative easing programs [see Why Commodities Belong In Your Portfolio].
But when it comes time to add these tools to a portfolio, many investors are unsure which options are correct for them. The two most popular methods for gaining exposure to futures comes in the form of physical and futures-based allocations. The two have very different qualities that may appeal to certain investors, making one choice better than the other, depending on investment objectives.
Futures investing has long been the traditional method for establishing positions in a particular commodity. Investors have a wide range of options, as the CME offers contracts on everything from gold and silver, down to butter and orange juice. Futures allow for investors to quickly move in and out of positions on commodities and are meant for more active traders. While it is possible to buy and hold a contract that does not expire until years down the line, if a contract is held until maturity, the contract will deliver the specified amount to the investor. And when it comes to something like livestock or crude oil, not many investors want that showing up at their doorstep because they forgot to sell their contract [see also Invest Like Jim Rogers With These Three Agriculture Stocks].
In general, futures contracts can be difficult to trade as they require the use of a futures account, which are notoriously hard to navigate. These investments can be very complex and are not meant for the average investor. For those who do understand the ins and outs of futures trading, it can be a very useful tool for those willing to actively monitor positions. Investors looking to make a long term play on futures contracts can purchase an exchange traded product which has an automated roll process of futures contracts, but these come with their own set of problems. ETPs can trade off from the spot prices of the futures they track, and are also victims to contango and backwardation in the roll process.
When futures markets are contangoed–near month futures are cheaper than those expiring further into the future–the roll process can mean selling low and buying high, thereby creating some significant headwinds for investors. Exchange traded commodity products are powerful tools, but can lead to undesirable outcomes when compared to spot prices if used by those who do not fully understand the nuances of the products. The most important thing to remember about these products is that they should be thought of as a futures contract first and an ETP second. As a result, investors must realize that the contango is little more than the storage costs for a commodity by a different name, eating into returns in order to pay for these often significant costs. This process also works in reverse, called backwardation, which may work to an investors advantage [see also Company Spotlight: First Solar (FSLR)].
Some investors choose to simply buy and hold on to the physical commodity that they wish to own. This eliminates all of the issues seen in a futures contract, as you can physically hold what it is that you have bought and not have to worry about the complexity that saddles futures. But physically owning a commodity comes with a considerable downside. For starters, most physical purchases, like that of a gold coin, will come at a premium, leading to high costs. Buying a physical commodity can also be extremely expensive, where the initial capital required for a physical ounce of gold would be well above a gold futures contract. And finally, selling your commodity may be an issue; it may be difficult to find someone who will buy several ounces of gold or platinum at a fair price, issues that futures do not generally worry about.
The exchange traded world gets around some of these issues with physically-backed products, which represent physical exposure to certain commodities though it never enters an investors’ hands. This eliminates the cost of buying a commodity up front and worrying about who will buy it when it comes time for you to sell. Physical exchange traded products do not deal with contango or backwardation, and investors never have to worry about delivery. Though there are storage costs associated with a physical ETF, it usually amounts to very little, allowing investors to keep the majority of their gains [see also Analyzing Five High Yielding Oil & Gas Pipeline Stocks].
The problem with these products, however, is their limited reach. There are currently just a handful of funds offering exposure to physical commodities and investors can only buy physical precious metals for the time being. While more physical products have been planned, the market has been slow to branch out into different commodity types.
Deciding between these two exposure methods can make a big difference in bottom line returns for an individual investor. Futures investing offers exposure to a wide variety of commodities at a relatively low price. But these contracts can be very complex, and need to be monitored often. As such, these funds and contracts are meant for more active traders, though active traders have been known to dabble in physically-backed products like the SPDR Gold Fund (GLD). The “buy-and-hold” investor will profit from physical commodity holdings. The space is very limited for the time being, but it allows for a safe long-term play on a particular niche without having to worry about the issues that saddle futures-based investments. Long-term investors can also buy a futures ETP, but these should be approached with caution, as their gains can be quickly eaten away by contango or backwardation depending on the position.
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Disclosure: No positions at time of writing.