- Commodities futures funds and commodities index funds provide investors an efficient way to gain exposures to the commodities market, an asset class which was previously difficult to access.
- However, commodities can be a highly volatile asset class, and investment in commodities related investments may expose investors to a high level of risks.
- The performance of commodities futures fund or commodities index funds may not correlate with the performance of the underlying commodities due to imbalances between expectations on futures contracts and the current price of the commodities.
How are commodities traded? How can investors get exposure to the commodities market?
Commodities can be traded via a range of financial instruments, including: principal-to-principal contracts for physical commodities, over-the-counter derivatives, exchange-traded derivatives, private investment pools, mutual funds and exchange traded funds ("ETFs").
Physical commodity market investments are impractical for most investors due to the complications associated with owning the physical goods. Storing physical barrels of oil, bushels of corn, bags of coffee, etc is expensive and logistically challenging. Investors can therefore obtain commodity exposure by way of, commodities futures, commodity-linked stocks, commodities equity funds, commodities futures funds and commodities index funds.
How are commodities futures contracts priced? What is the relationship between the spot price and the future's prices? How do they change relative to each other and their potential impact on funds investing in commodities futures?
Futures contracts are binding agreements, made through futures exchanges, to buy or sell a commodity at a specified time in the future. Futures contracts are standardized according to the quality, quantity and delivery. Commodity futures' prices are discovered on exchanges between the market participants, and maybe different from the spot price. So the performance of commodities futures funds may differ from the current market or spot price performance of the underlying commodities. Imbalance between expectations on futures contracts and the current price of commodities may result in the futures price being higher or lower than the current price of the physical commodities.
The situation where the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery, is known as "contango" (i.e., carry structure). The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as "backwardation". When the deliverable commodity exists in plentiful supply (e.g., corn after the harvest) and demand is stable, the market is typically in "contango". The cost of carry for commodities is primarily determined by interest rates and the cost of physical storage. When the deliverable commodity is in short supply (e.g., corn before the harvest) and demand is heightened, market forces of supply and demand may drive the market into "backwardation".
When the deliverable commodity exists in plentiful supply (e.g., corn after the harvest) and demand is stable, the market is typically in "contango". The cost of carry for commodities is primarily determined by interest rates and the cost of physical storage. When the deliverable commodity is in short supply (e.g., corn before the harvest) and demand is heightened, market forces of supply and demand may drive the market into "backwardation".
What do commodities index funds hold in their portfolios?
In order to provide the greatest possible correlation with the performance of the chosen commodity index, the funds will generally purchase either a basket of commodity futures or over-the-counter financial derivatives linked to the performance of the relevent index. However, depending on the specific structure, the funds may also invest in debt securities, stocks and other derivative instruments.
Are there any differences between an index fund that tracks a stock index and an index fund that tracks a commodities index?
Index funds that track stock indices have similar construction to and are transacted similarly to index funds that track commodity indices. The clear differences between them are the underlying products that they aim to replicate and the financial instruments employed by the funds to hedge their relevant index exposures.
What are the special features of commodities index funds traded on an exchange (ETFs)?
Commodities index funds traded on exchanges (ETFs) allow investors to access baskets of commodities via liquid financial instruments listed on stock exchanges. The funds aim to replicate the performance of chosen commodities indices, and hence they will be fully exposed to the commodities sector risk and the downward price changes in the commodities index as ETFs are not actively managed.
What are the benefits and risks of investing in Commodities ETFs?
- Simplicity: investors are able to obtain index exposure in one transaction.
- Flexibility: they are traded at real-time market prices, making it possible to react quickly to market movements. Investor can also take advantage of short selling.
- Transparency: they meet market-making requirements on their respective stock exchanges and are continuously quoted throughout the sessions.
- Cost effective: most funds do not have subscription or redemption fees (although normal brokage fees typically apply) and fund management fees are competitive in relation to other commodity index linked investment products.
- Commodities index funds are subjected to risks associated with futures contracts or over-the-counter financial derivatives, which they generally hold.
- Commodities are generally subject to rapid change and the risks involved may change relativelt quickly. The price of commodities can be highly volatile.
- Commodities are often produced in emerging market countries and these countries are more exposed to the risk of swift political change and economic downturns.
- Performance of Commodities ETFs may not correlate with the performance of the underlying commodities due to imbalances between expectations on future contracts and the current price of the commodities.
Will the constituents (i.e., commodity futures) of a commodities index change? If so, how will this change affect the corresponding commodities index fund? How can one get more detailed information about the index, its constituents and its performance record?
The constituents (i.e., commodity futures) of commodities indices change occasionally in accordance with each commodities index's pre-defined rules for constituent eligibility. Eligibility requirements in the underlying baskets of commodity futures typically entail parameters based on, among other things, the liquidity of the futures contracts. Many indices also make provisions in their rules for their respective Oversight Committees to make constituent changes based on exceptional events or market conditions. Changes to the constituents generally have a minor impact on the composition and returns of a given index given that commodity indices are broadly diversified. Detailed information and historical data for each commodity index are usually made available to the public via the index sponsor, the commodity index fund manager and data vendors.