Commodity Investing: Physical vs. Futures

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-Based

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)].

Physical-Based

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.

Verdict

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.

This entry was posted in Commodity ETFs, Commodity Futures. Bookmark the permalink.

Commodity HQ is not an investment advisor, and any content published by Commodity HQ does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities or investment assets. Read the full disclaimer here.

10 Responses to “Commodity Investing: Physical vs. Futures”

  1. [...] Digging through Barrick’s stock reveals a lot more about the company. For starters, many investors will be happy to see a healthy market cap of approximately $48.5 billion and an average daily volume of over 10 million, making the stock eligible for both active traders and traditional investors. Looking closer at in-depth financials for the company, ABX has strong earnings and revenue growth on a quarterly basis while its P/E ratio is below 13, suggesting that it is still reasonably valued given its growing revenue prospects. Investors should also note that the company has met three of their last four earnings estimates, suggesting strong and stable fiscal management behind the scenes [see also Commodity Investing: Physical vs. Futures]. [...]

  2. [...] Cocoa trees require a warm climate to thrive, specifically within 20 degrees north or south of the equator. There are two different types of cocoa plants: Criollo and Forastero, with Criollo being the most sensitive to weather conditions, making it more difficult to grow and harvest properly. The cocoa trees take approximately five years to reach maturity, and each tree can produce roughly 2.2 pounds of cocoa. The cocoa beans themselves are about 3 cm thick with the center filled with a sweet pulp called mucilaginous. The seeds are typically white, though they turn a reddish brown color during the drying process [see also Commodity Investing: Physical vs. Futures]. [...]

  3. [...] Today, coal is primarily used as energy for power plants the world over, helping to generate roughly 40% of the world’s electricity. Although concerns remain over its relatively ‘dirty’ nature when compared to other fuel sources, the fact remains that coal is by far one of the cheapest and most abundant sources of fuel in the world today. Despite coal’s ubiquitous nature, there are very few options for investing in the product. Beyond exchange-traded futures contracts, investors can only buy up coal mining companies or obtain broad-based exposure to the industry via ETFs [see also Commodity Investing: Physical vs. Futures]. [...]

  4. [...] Zinc, also known as spelter, is a metallic element which is used all across modern communities. Aside from being an important industrial metal, the commodity is also an important mineral to the human body, as a zinc deficiency can cause major health problems. The metal is typically found with other base metals, like copper, and is also a founding component in the Earth’s crust. Estimates of zinc resources total to approximately 1.9 billion tonnes worldwide, making this important metal an abundant resource. In fact, zinc is the fourth most popular common metal in use, with a global annual production of around 10 million tonnes. As an investment, zinc has steadily gained popularity as a way to play global markets due to the fact that this metal is so commonly used in not only the industrial world, but other aspects essential to everyday life [see also Commodity Investing: Physical vs. Futures]. [...]

  5. [...] Trading commodities has been popular for many years, as investors can use a number of different resources to gain access to their favorite commodity investments. But it was only a more recent development that commodities earned their keep in a long-term portfolio. Now, a small, but important, allocation to commodities is a necessity of any well diversified portfolio, as these investments offer a number of advantages such as hedging against inflation and maintaining low correlation levels to traditional asset classes [see also Commodity Investing: Physical vs. Futures]. [...]

  6. [...] From an investment standpoint, the term petrol or gasoline, refers to Reformulated Gasoline Blendstock for Oxygen Blending (RBOB), which is simply the term given to unleaded gas futures. Seasonally, gas futures tend to dip in the winter months, November and December, and reach their peaks between April and May. Because the United States is the largest consumer of gasoline, how our nation uses gasoline can have a major impact on global prices [see also Commodity Investing: Physical vs. Futures]. [...]

  7. [...] Coal has long been a major source of energy for the world and while it may not be the cleanest burning fossil fuel, it will certainly remain an important energy source for many years to come. One of the most valuable coal miners comes from Yanzhou Coal Mining Company (YZC). The company is headquartered in the People’s Republic of China and is the only coal mining stock to be listed on all three of the Hong Kong, Shanghai, and New York Stock exchanges. YZC as a stock is popular among traders with a nice daily volume of 275,000 and a market cap eclipsing the $12.8 billion mark. Its dividend yield of 3% will make for a nice coal allocation to your portfolio while adding a steady stream of income [see also Commodity Investing: Physical vs. Futures]. [...]

  8. [...] The fee structure of these two products is another important factor that investors will need to take a close look at. CROP comes at a price of 75 basis points, not terribly expensive given the small cap nature of its exposure. MOO, however, charges just 59 basis points in comparison. While this certainly makes it the cheaper option, it is still relatively expensive for a large cap product and may turn some investors off. Unless you are a heavy hitter, the 16 point spread won’t hit you too hard; a $10,000 investment would net to about a $16 annual fee difference in the two funds. But for those looking to make big bets, MOO’s cheaper expenses may save you a fair amount of money over the long term [see also Commodity Investing: Physical vs. Futures]. [...]

  9. [...] In addition to copper wire and copper piping, the reddish-orange metal is used in power generation and transmission, heating and cooling systems, and telecommunications equipment. Copper is a key part of motors, brakes, and other auto parts, and is widely used in electronic products as well. Copper is also used in statues; the Statue of Liberty, for example, contains more than 80 tonnes of copper [see also Commodity Investing: Physical vs. Futures]. [...]

  10. [...] since it is an ETF whose shares represent beneficial interest in a trust which actually holds physical bars of platinum. Investors should bear in mind that ETNs are debt obligations of the bank issuers – [...]

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