A Route to Commodities that Bypasses the Futures Market

The love affair with commodities continues unabated. Whether they’re looking for diversification, an inflation hedge, or to speculate on rising prices, investors have plowed hundreds of billions of dollars into commodity-related offerings, including both mutual funds and exchange-traded funds (Exhibit 1). Investments in commodity mutual funds, for example, grew to more than $137.6 billion by the end of 2011 from $9.2 billion at the end of 2002. The growth story for commodity-tracking ETFs is even more impressive. Assets skyrocketed to $150.4 billion from $770 million over the same period.

Suffice it to say that we’ve come a long way since legendary investor and commodity aficionado Jim Rogers lamented, “Commodities get no respect.” This statement would be far from the truth today.

Ways to Invest in Commodities
There are three avenues to gain exposure to commodities:

1. Physically Hold the Commodity
Physically backed exposure offers perfect tracking (net a management fee) to the underlying commodity, because the investor owns the physical commodity. For most investors, however, this is really only practical for commodities that have a high value/weight ratio, such as gold.

2. Buy Commodity Futures
Investors hold futures contracts that obligate the purchase or sale of a set quantity of a commodity, at a set date in the future, and at a set price. There are three main return drivers of futures-based investments: spot return, collateral yield, and roll yield (gains or losses incurred when a contract expires and is rolled into the next one). A good futures-based strategy attempts to optimize these return drivers. But the futures market can be multifarious, requiring investors to have a thorough understanding of how roll yield works.

3. Purchase Equity of the Producer
Choosing the equities of commodity producers has broad appeal for investors. Equity vehicles, such as stocks, are convenient, easy to access, and are less complex than playing the futures market. Using commodity equities also widens the opportunity set to gain exposure to the asset class. Not all commodities have futures associated with them, such as iron ore, timber, water, and coal.

It’s also feasible that commodity equities will outperform the commodities themselves in a rising-price environment. For any given percentage increase in price, a producer’s profits will increase by a greater percentage, all else equal. This leverage to commodity prices is greater for higher-cost producers (those with lower profit margins). Furthermore, higher prices usually mean that more of a company’s resources are economical to produce.