|There are ways of making money
in commodities. But buying into a commodity fund - or any other
investment in commodities that is open to the private investor
- is not one of them.
'Commodities' means basic raw materials like gold,
copper, sugar, cattle. To be of any financial interest they must
be easily tradeable.
There are three things you can do with commodities:
- Buy the physical product, take delivery of
it, store it, and then either consume it or sell it - arranging
for delivery to the buyer according to agreed instructions. This
is called dealing in 'physicals'.
- Make a forward contract to buy (or sell)
the product some time in the future. Later you may either take
(or make) delivery or get out of your contract by selling it to
- Trade in futures contracts on a futures
As a small private investor your only way of investing
in a commodity is to buy a commodities fund. A commodities fund
may be doing any or all of the above.
An average equity share will make money over
the long term because that's what the company is trying to do. An
average cash deposit will earn interest. But all a commodity does
is sit there. It does not produce income. So an investment in commodities
is paddling upstream.
It's worse. Commodities cost money to keep. These
costs are called holding charges - storage, finance, insurance and
Then there are the management charges. Any form of
private investor exposure to commodities will incur them, and they
will be steep.
So a commodities fund has to work very hard trading
in forwards and futures to make more money than the average share.
In choosing to invest in commodities instead of equities you are
betting against the odds. Or backing your judgement. Good luck
So why do we read of people
making fortunes in commodities?
Because of leverage.
Commodity contracts usually operate on margin. Only a small proportion
of the contract value need be put up in cash, which magnifies both
profits and losses. Allied to 'survivorship bias', which clears
out the losers. Allied to the journalistic habit of 'picking peaks'.
Gold is special because of its place in the monetary system. It
has its place as a hedge against currency debasement. It may occasionally
be right for individuals to invest in it. But only under the direction
of a good investment adviser.
Really it is unfair to put this warning under 'Commodities' because
it applies to all investment products that are a little out of the
ordinary. But the dependence of commodity funds on futures trading
makes these questions particularly relevant.
What do you know about:
- the regulations under which the fund operates,
and the compensation available to the private investor for fraud
- the fund's internal dealing controls that
ensure that trades are placed in the correct accounts? Remember
that trades a few minutes apart can be at different prices, so
you do not want any hanky panky between your account and the House's
trading for its own account
- your fund's trading risk limits (if any)?
- the financial strength of your trading house
and the financial consequences for you of its collapse?