Thursday, May 27, 2010

You Too Can Be a Commodities Speculator

If there is a magic to investing, I believe it is this: on average, investing is a game of chance where you win more often than you lose. This is because underlying a quality investment is a business idea or a use of resources that produces more than it consumes. If I provide capital to a business (whether buying stocks or bonds) that business might be able to grow and add value. Thus my investment isn't just a zero sum speculation where I hope to guess better than others - it's a chance to create something new.

Of course, that's not really true if you are a commodities speculator. I received this note from Fidelity the other day. The idea is pretty simple: if you're a long term investor, you should have some exposure not just to stocks and bonds but also to commodities.

The problem: it's a terrible idea. Commodities "investing" isn't investing at all. It is speculation. You are making a bet that commodities will be more expensive in the future. That's the only way you will make any money. A business borrows money and pays interest because they believe that what they can do with the money will generate more cash flow than the interest payments. A business issues equity (stocks) because they believe that they will be able to retain earnings (that is, make a profit that will belong to the stock holders) or pay dividends to the stock holders.

What kind of a dividend does a barrel of oil pay? What interest rate do you get on a bushel of wheat? Here's a hint: zero. Commodities "investing" strips away the "investment" part of investing and leaves only the speculative component.


The traditional way to invest in a commodity is to hoard it - that is, to buy a claim on production of that commodity and then sell it later when it's worth more. It's hoarding, plain and simple. When you buy a bond, your capital is temporarily useful to someone else - you are making available capital more plentiful. When you hoard a commodity, you're simply taking away from everyone else.

And this brings me to my first major concern about commodities speculation via hoarding: it bites back. If enough people hoard enough of a commodity, the price rises (through increased demand) and one or two things happen:
  1. Suppliers of the commodity increase production, anticipating support form higher prices. (E.g. oil producers start drilling more wells.) This increases supply, which will lower the value of your hoard.
  2. Real users of the commodity find alternatives to using the commodity. (E.g. cars become more fuel efficient.) This lowers demand, which will lower the value of your hoard.
In other words, the value of your commodity is influenced in the wrong direction by your interference in the market. And most commodities markets are quite small relative to capital markets; when investors all decide they want to buy oil, they overwhelm the actual users of oil.

It Takes Two To Contango

The second concern is the cost of hoarding. Even if you do want to hoard, how do you do it? Most ETFs don't stash commodities in a warehouse because that's expensive. Instead they buy forward contracts, which require them to buy the commodity in the future. When delivery time comes around, they then sell the commodity (at the price for the commodity with immediate delivery, called the "spot price") and buy a new future, "rolling" the commodity contract. By doing this forever, the ETF can claim a commodity without ever having the real materials show up.

The problem with this is that the price of the futures contract and the "spot price"aren't the same. If the spot price is lower than the futures price, the market is in "contango". Let's review that transaction. Once a month the ETF sells at the spot price, buys at the future price and...uh oh. We're losing money with every transaction and making it up in volume.

There are some good reasons for commodities markets to be in contango - in particular, if a ton of investment money is trying to roll futures contracts, the increased demand for futures and supply of spot is going to drive the market into contango. The gain or loss is called "roll yield" and it's been negative for a while, since so many "investors" decided to speculate in oil a few years ago. Even if your speculation is correct, making the profit minus roll yield might not be much fun.

A Lot To Pay For Stock

Fidelity suggests a series of mutual funds with exposure to commodities. The letter specifically quotes the manager of the Fidelity Global Commodity Stock Fund (FFGCX). This fund hasn't been around long enough to look at its correlation and beta, but there is one statistic that sticks out to me immediately: the 1.42% expense ratio. (Fidelity has been generous to subsidize the fund to get the expense ratio down to only 1.25%. Great.)

The other funds have expense ratios of about 0.9%, betas greater than 1 (meaning they are more volatile than the whole stock market) and R-squared of about 0.5 (meaning that when your stocks tank, they're going to tank a bit too).

Basically you're paying higher fees to buy volatile stocks that will still take a hit when the market tanks.

In summary, investing in commodities:
  • Isn't really investing at all.
  • By its very nature forces down the commodity you are investing in.
  • Costs real money just to speculate.
  • Is still expensive when done via corporate exposure (which isn't even a direct play on a particular commodity).
But I don't think that any of this has to do with why Fidelity is advocating commodities. I'll explain what's really going on here in another post.

1 comment:

Jonathan said...

One thing your post fails to note is that the product being advertised is not the actual commodity, but stock in the companies that create the commodities. You're not buying a barrel of oil, you're buying a share of the profits from making barrels of oil. While this will still get creamed is people stop wanting oil, it does represent a revenue stream, just like normal stocks, and you can (and probably should) invest in it. Just not more than anything else.