With investors still smarting from the financial crisis, many are rethinking the asset allocations of their investment portfolios. An increasing number are delving into alternative investments, seeking diversification and lower volatility. One asset class investors are finding particularly alluring is commodities. To become an informed investor, you should consider the potential benefits of this enormous asset class.
What are Commodities?
Commodities are agricultural products and raw materials that can be bought and sold. The two main categories are ‘hard’ commodities that require significant effort to be mined or extracted such as (gold, copper, silver and oil) and ‘soft’ commodities like agricultural products (coffee, pork bellies, sugar and wheat).
The physical commodity space is enormous, with global production value of the 23 largest commodity markets was over $8 trillion in 2011.1
Where do Commodities Trade?
While the East Coast’s Wall Street boasts the excitement for stocks and bonds, the real action for commodities is in the Midwest with the Chicago Mercantile Exchange, CME. The CME Group also owns the Chicago Board of Trade, the New York Mercantile Exchange and COMEX.
From humble beginnings in the 1800s as the ‘Chicago Butter and Egg Board’ the exchange has become a powerhouse in the trading of various derivatives. Also offering financial futures (foreign currencies, interest rates and equity indexes) CME Group has the largest open interest of futures contracts of any exchange in the world.2
The floor of any exchange can be very exciting. The CME still utilizes the traditional ‘open outcry’ system of trading where order clerks, runners, and traders scream and flash hand signals maniacally. While it seems like mass chaos, there are rules on the CME floor which are closely self-regulated. Traders can, and have been fined for running or fist-fighting on the floor.3 The modern technology of electronic trading has made the New York Stock Exchange seem like a museum by comparison.
How do Commodities Trade?
Commodities typically trade via futures contracts, agreements between two parties to buy or sell a good at a specific price in the future. These contracts are listed on exchanges, like the CME. There are typically two ways these contracts can be executed or settled-‘cash’ or ‘physical’.
Futures trades mostly end up as ‘cash commodity’, where the contracts are settled for cash. These are typically done by speculators or hedgers. A speculator may be a hedge fund that wants to bet on the price of corn going higher. The fund would purchase corn futures contracts. But they only want to speculate on the price movement of corn, they don’t want to actually possess bushels of corn. So it’s settled in cash, like a trade.
Hedgers are institutions that require access to the underlying commodity through the regular course of business. Typical examples include banks hedging interest rate risks, farmers locking in a future price for crops and airlines who want to keep their fuel costs affordable. For them, futures trading are used to minimize risks and hedge costs, not outright bets.
There are also financial futures on the S&P 500 (known as the ‘E-Mini’) which are very popular, especially the more global financial markets become. Using financial futures contracts is one way that a trader can hedge his position’s exposure at a time when trading in their stock markets are closed.
Hedging is a crucial risk management tool for many businesses and the failure to hedge can cause disastrous results. Energy exploration and production company Continental Resources is an unfortunate example of a company that reportedly did not hedge against the downturn in oil prices.4 The company’s stock (Symbol: CLR) lost 82% of its value from its September 2014 high to its January 2016 low.
The company’s stock (Symbol: CLR) lost 82% of its value from its September 2014 high to its January 2016 low.
Physical delivery involves settling the futures contract with actual delivery of the underlying commodity, whether that’s barrels of crude oil, grain or frozen concentrated orange juice. Typically, the executor of a contract takes physical delivery at a predetermined site, typically a designated warehouse or ‘elevator’.5
Most exchanges allow for a trader who doesn’t want to take physical delivery to “retender” the contract with the exchange. Physical delivery represents a very small amount of futures settlements, only about 2%.6
What Factors Influence Commodity Prices?
Commodities tend to trade on typical supply (crop levels) and demand factors (demographics). But there are other factors that are very important including weather patterns, diseases and geopolitical concerns. Traders assess these variables and also study the price movements of the commodities, known as technical analysis.
Government policy can also play an important role in determining commodity prices. Sometimes, governments can control a critically important commodity as has been seen with countries nationalizing oil production and monopolizing rare earth metals.7
Today, many rare earth metals are found in China. As the name implies, rare earth metals are not readily available like other commodities because of various conditions. This can include scarcity, difficult mining conditions or restricted access from foreign governments. Metals such as molybdenum, dysprosium and europium may not be household names, but they are crucially important for industrial, as well as military applications.8
What are CTAs?
Commodity Trading Advisors, CTAs, are licensed investment professionals that deal with the buying and selling of futures contracts for customers (known as managed futures). Since futures contracts are derivatives that employ a high degree of leverage they require oversight by a professional with specific training and a specialized license. CTAs are charged with navigating the commodity landscape for their investors or customers.
They employ a few different actively managed strategies for clients including quantitative, fundamental and technical. Quantitative strategies, like statistical arbitrage, involve statistical analysis on price patterns. Fundamental analysis uses supply and demand forecasting to predict price movements. Technical analysis is very important to many CTAs. Certain strategies rely on this such as a trend-following, systematic strategy (which has proven the most popular and profitable for CTAs over time).9
Few financial markets are as exciting as the commodities, maybe none more than oil. When West Texas intermediate crude oil lost over 75% of its value from June 2014 to February 2016, there seemed little hope for ‘Black Gold’. We began reading reports and headlines calling for oil to go to the teens and even $10 from major banks like Standard Charter.10
With all the negative headlines and sentiment on oil, it seemed the price of oil was a one way street. But when sentiment gets so lopsided, it can often be a prescient contrary indicator. Case in point, oil soon jumped back from $26.05 to $39.02 per barrel this week-a 50% gain in less than a month. An experienced CTA utilizing technical analysis may be able to see such signals.
While it may appear that commodities are more volatile, as a whole, they may actually be less volatile than equity markets. Because commodities have historically low correlations to stocks, including them in an investment portfolio may actually reduce overall portfolio risk.11
If this sounds exciting to you, consider a career in finance as a CTA. Candidates must first pass the National Commodities Futures Exam (known as the ‘Series 3’), be licensed with the Commodities Futures Trading Commission and have membership in the National Futures Association, NFA. Depending on how large your CTA business is, you may have to also register with the SEC or state regulators.
With greater interest in managed futures by institutional investors (pension funds and endowments), there has been an explosion in assets under management by CTAs. BarclayHedge reported assets jumped 500% between 2001 to 2007, ending at over $200 billion.12 Once you get through the rigorous qualifications the CTA space can be a very lucrative career as sentiment continues to shift away from traditional stocks and bonds and towards alternative investments.