Introduction to Commodities

One of the hedge fund strategies that have not been detailed before is managed futures.  This strategy actively invests in futures and forward contracts on currencies, securities (such as stocks, bonds, ETFs and indices) and commodities.  This article will touch on the latter.  Commodities are used in the economy to produce finished products.  Some examples of raw commodities are gold, silver and oil.  Some finished products are cars, computers and cell phones.  An investor may buy/sell commodities through six vehicles.

An investor can purchase the commodity.  For most of them, it is not realistic as the investor would have to transport and store the commodity somewhere.  When it is sold, then it would have to be delivered.  It is easy to do when an ounce of gold is involved;  not if it is several hundred barrels of oil.

A more conventional way is to buy securities of companies that buy, produce and sell commodities.  Additional risks are introduced using this method.  Stocks and bonds are influenced by stock and debt market conditions that have little relationship to the commodity markets.  They also are affected by corporate events such as mergers, buyouts, bankruptcies, etc.  Finally, as part of companies' risk management efforts, they hedge their positions against the commodity.

A third way is to buy or sell futures contracts that are sold on public exchanges.  This is an option that allows the investor to buy or sell the commodity at the strike price at the expiration date.  Settlement is done in cash. There is inherent leverage in futures as investors can put up 10% of the price to buy them.  This is called the initial margin.  Depending on the value of the contracts, investors may be subject to margin calls to maintain a minimal investment amount.

The investor can buy or sell private option contracts called swaps or forwards.  These are between two counterparties with no exchange involvement.  These are customized but have much less liquidity than futures. The investor is subject to the risk that the counterparty may default.

The fifth vehicle is a commodity-linked note.  These are intermediate-term debt securities that may or may not have their principal protected.

The last one is an ETF.  It can be bought on an exchange and is just like an equity ETF.  For example, GLD gives the investor a position based on the price of gold.