Introduction to Commodities

Investing in commodities has the potential for large returns and great portfolio diversification. Although this asset class was once traded by few active investors, in recent years it has shown such high returns that it has generated a substantial amount of positive attention and intense investor interest.

Thanks in part to the billions of dollars that have been recently injected into the asset category by various new funds initiated by several investment firms, investing in commodities is now easy. Estimations by Barclay’s Capital set the total amount of investments in these funds at around $110 billion dollars in early 2007. This huge figure has insured a great deal of support for returns on investments in commodities.

Risks

If we are unreasonable about our expectations, however, or frivolous about our investments into commodities, disappointment is likely. Despite the great long-term returns and excellent potential for diversification, investing in commodities can mean the assumption of risks well above one’s initial investment. If you are interested in investing in this dynamic section of the market, it’s important that you understand the potential risks.

Some of the most mature and time-honored markets in the US, the commodities markets grew from the demand for stable prices by both producers and purchasers of commodities. Those interested in a stable price give some of their potential earnings or savings to an investor in exchange for that investor being willing to take on the price fluctuation risk. Because investors can take on the risk premium whether the price of the commodity is falling or rising, the returns are not directly connected to the price fluctuations.

There are a number of ways investors can get involved in the commodities markets. Each of these has its own level of returns and risks.

Managed Futures Accounts

The first way to invest in the commodities markets is investment in a managed futures account. All trading in these accounts is performed by registered commodity trading advisors. If you have only a small amount to invest, your money will be placed into a pool together with that of other small investors, and a CTA will be hired to make the trading decisions. If you have a larger amount to invest, generally over one million dollars, you may open your own account.

Because the objectives of these accounts can often be leveraged, focused on particular markets, and looking to make money off sudden price fluctuations in their commodity of choice, these investments are usually quite risky. Investors are only required to deposit a tiny percentage of the total value of the contract, and this means that the potential profit or loss can be much greater than the initial amount invested.

Commodities Futures Index Funds

A second way to invest in the commodities markets involves fully collateralized, passively managed futures index funds. Unlike managed futures accounts, commodities futures index funds do not try to capitalize on price fluctuations in the commodity of choice. Instead, their returns come from insurance premiums found in commodities future contracts. Concurrently, if sudden favorable price fluctuations occur, these funds will reap premium returns. If, however, the sudden price fluctuations are not favorable, the loss will be muted.

In general, these funds usually invest into a varied group of commodities future contracts. Because of this diversification and the pre-established method by which these contracts are handled, these funds generally reap steady amounts of consistent returns.

Stocks

Another way to get involved in the commodities markets is to invest in the stocks of corporations that supply commodities. This is a very low-profit area, however, as studies have illustrated that the risk and return qualities of investing in these stocks are much less favorable than those that come with investing in commodities futures index funds. In fact, over the interval studied, investments in the stocks of corporations that supply commodities returned only about a third of the amount returned by investments in fully collateralized, passively managed commodities futures index funds.

Commodities Investment Returns Outlook

Even though returns on investments into commodities markets are not necessarily completely reliant on increasing prices, they are still somewhat connected. Since the 1970s, returns have been shown in only three years out of the 11 total years in which the spot index has declined. And until the 2006 commodities boom provided the exception, returns had been shown in every single year in which the spot index had grown.

Specifically due to the continued global economic growth and increasing worldwide demand for both raw materials and energy, commodity prices do not appear to be heading for a decline any time soon. Investors should, however, be uneasy about the increased interest in the commodities markets. As interest increases, risk premiums decline and returns begin to drop. Future premiums should not be expected to yield as much as they have in past years.

However commodities make up a good part of the fundamental requirements of human survival, so as long as there is commerce, there will be commodities.