Commodity Investment Features
Commodities themselves do not generate cash flows but usually incur costs (cost of carry introduced in derivatives learning modules), such as those for transportation, storage, and insurance for physical commodities. Investors seek to benefit from commodity price appreciation (in excess of carry cost) based on their future economic value rather than actual use of the underlying asset.
Distinguishing Characteristics of Commodity Investments
Commodities may be further classified by physical location and grade or quality.
For futures contracts, counterparty risk is managed through the settlement process between the clearinghouse/exchange and clearing brokers. Commodity exposure can be achieved through means other than direct investment in commodities or commodity derivatives, including the following:
- Exchange-traded products. ETPs, either funds (ETFs) or notes (ETNs), may be suitable for investors restricted to equity shares or seeking simplified trading through a standard brokerage account. ETPs may invest in commodities or commodity futures. For example, the SPDR Gold Shares ETF seeks to track the price of physical gold by holding bullion in vaults. It owned just under USD53 billion in gold bullion as of December 2022. ETPs may use leverage and may replicate the pay-offs from a long or short position, with the latter form considered inverse or “bearish.” Similar to mutual funds or unit trusts, ETPs charge fees included in their expense ratios.
- Investing with commodity trading advisers. CTAs are another way to gain commodity exposure. CTAs are managed futures funds that make directional investments primarily in futures markets based on technical and fundamental strategies. A commodity-focused CTA might concentrate on a specific commodity (such as grains) or be broadly diversified across commodities. However, one would need to find a fund focused solely on the desired commodity, because modern CTAs often invest in a variety of futures, including commodities, equities, fixed income, and foreign exchange. Individual investors may establish accounts that are managed in accordance with their specific investment preferences and risk tolerance called separately managed accounts (SMAs). These types of individual accounts are common for commodity investments. More details on CTAs and managed futures are covered in the learning module on hedge funds.
- Specialised funds investing in specific commodity sectors. An example of specialised funds is private energy partnerships, which are similar in structure to private equity funds and enable institutional exposure to the energy sector. Management fees can range from 1% to 3% of committed capital, with a typical life span of 10 years and extensions of 1- and 2-year periods. Publicly available energy mutual funds and unit trusts typically focus on the oil and gas sector, often acting as fixed-income investments to pay dividends from rents or capital gains. They may focus on upstream (drilling), midstream (refineries), or downstream (chemicals). Their management fees are comparable with those of other public equity managers and range from 0.4% to 1%.
Basics of Commodity Pricing
The pricing relationship between cash, S0, and derivative markets can be expressed under continuous compounding as
F0(T) = S0e(r+c–i)T,
