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Commodities (pt 2)

This is an article about commodities and how they relate to investing in general, not Orbis Access in particular.

Advantages of commodities

Not quite like the supermarket

ETF revolution

It has long been possible to invest in commodities by buying and selling derivative contracts (such as futures and options) on various Commodities Exchanges around the world. Though some brokerages provided access to these markets, they were largely the domain of professional investors.

However, trading in commodities has been transformed in recent years with the emergence of Exchange Traded Funds (ETFs) and Exchange Traded Commodities (ETCs). This has made investing in commodities relatively straightforward and accessible to everyday investors.

Nowadays investing in commodities can be done in the same places you manage your other investments, such as bonds and shares. 

Hundreds of commodity-based ETFs are available, covering dozens of different commodities. Some ETFs concentrate on a single commodity, while others track an index reflecting the price of a basket of them (such as ‘metals’).

Physical vs. Synthetic

When considering investments here, it is important to be aware of the distinction between physical and synthetic ETFs.

For example, some gold ETFs actually buy physical gold. Others, though, may not have a warehouse full of precious metal. Instead they have contracts promising delivery of a suitable amount of the stuff in future. This may be perfectly above-board, but at first sight the physical option appears more attractive.

(That said, investing in a physical ETF is still one step removed from actually owning the commodity yourself. You can physically hold a gold coin you own, after all. In practice, you don’t actually ever get to see or touch the gold in your physical ETF).

With other commodities it is rather less practical to take possession of the physical product. Take oil. Where is your ETF manager going to stick £1bn of that?

Instead of owning a reservoir of oil, the fund instead acquires a bunch of contracts promising delivery of oil in future. Before the delivery date arrives, these future contracts are replaced with new ones offering delivery dates further off. This happens on a rolling basis, so the fund never actually owns oil. It owns contracts. This makes it a synthetic (rather than a physical) fund.

Tracking error

The idea may be to track the price of oil, but with synthetic ETFs in particular the difference can be significant.

This ‘tracking error’ describes the difference in price between the fund and the actual market price of the commodity it is following.

With physical ETFs, the error may be small and largely down to fees related to managing the fund. But there can be other factors in play, particularly with synthetic ETFs.

The upshot is that there could be times when the price of a synthetic ETF (tracking oil or gas, say) behaves differently from the market price of the underlying asset it purports to be shadowing.

High tracking error, US natural gas spot price vs. gas fund

Commodities 2A

Low tracking error, Gold bullion price vs. gold fund

Commodities 2B

Source: Thomson Reuters Datastream

Mining stock

Rather than buying commodities directly, another option for investors is to buy shares in companies that produce, or extract, commodities.

The market value of a copper mining company, for example, will be influenced by copper prices. Higher prices may make the company more profitable, which in turn could fuel a rise in its share price. But ‘likely’ doesn’t mean ‘inevitable’ and of course the opposite applies if copper prices fall. Either way, there are plenty of other factors in play that can affect the value of mining companies, such as how well it’s managed.

Summary

  • There are several ways to trade commodities, such as ETFs, futures, mining stocks.
  • Each has particular risks and benefits. Make sure you understand them.